Monday, February 4, 2013

Cost Allocation and the American Heart Association


With National Heart Month now well underway, I thought it would be useful to take a look at the financial picture of the country’s largest heart health charity, the American Heart Association (AHA).  As discussed here before, the most widely used measure of financial effectiveness for charities is the program expense ratio, which measures the percentage of expenditures geared toward the organization’s primary mission (as opposed to fundraising or administrative efforts).  For the American Heart Association, the program expense ratio stands at a healthy 79% (based on its FY 2012 audited financial statements).  This financial effectiveness played a key role in the organization’s accreditation by the BBB and its 3-star rating on Charity Navigator.  However, it may not mean quite as much as people may think it does.  To see what is driving this ratio requires a diversion into cost allocation…


When an organization incurs an expense that is directly attributable to a particular functional area (programs, fundraising, or administration), the expense is assigned to that area.  However, it is often the case that organizations incur expenses for activities that span multiple areas.  Such “joint” costs must be split among the areas.  Accounting rules (specifically, SOP 98-2) stipulate several criteria for a joint cost to be allocated to a program expense category.  Despite the rules, there is substantial flexibility both in the classification of costs as joint and how to split them.  The end result is that charities often incur substantial joint costs and exercise discretion in allocating them.  In the case of the AHA, its total expenses in 2012 were $617 million, and over $227 million were deemed joint costs.

According to the AHA financial statements, these joint costs included primarily direct mail campaigns and special events. As an example of such joint costs, I received a mailing from the AHA that was part of its annual fundraising appeal.  It included (i) a letter asking for funds; (ii) a free gift of return address labels; (iii) a free gift of a valentine’s day card; (iii) an information sheet about stroke warning signs; and (iv) a return address envelope to mail donations.  Importantly, each of these components of the mailing also had some information on it about preventing heart attacks, strokes, or high blood pressure.  The inclusion of this information permitted all aspects of this mailing to be a joint cost and, thus, a portion of its cost was considered a program expense.  All told, in the case of AHA, over 70% of its joint costs were assigned to programs (primarily “public health education”).

The AHA is not alone in adopting this practice – to the contrary, it is the standard under Generally Accepted Accounting Principles.  One could argue, however, that the letter of the law may miss its spirit in that much of these joint costs arise from activities that are ostensibly fundraising in nature.  For this reason, a well-known watchdog, Charity Navigator, has gone so far as to ignore accounting rules and reclassify joint costs entirely as fundraising.  If one were to adopt this policy for the AHA (to date, Charity Navigator has yet to do so), its program expense ratio would drop to 53%, an abysmal figure by all accounts.  I am not proposing that the 53% figure is the correct one.  But, I am noting that the 79% figure, upon which everyone seems to fixate, does not tell the entire story.  The financial statements can help clarify a bit: they will tell us how much the organization’s joint costs were and how much were allocated to programs.  If donors want to know more than that, they must pressure organizations to be more open about their cost allocation choices.  In short, we probably know much less about the efficiency of the AHA than people tend to infer from its program expense ratio.

2 comments:

  1. I fit looks like a duck and quacks like it duck then the odds are it is a duck.

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  2. Hhhhhhhaaa yeah they are definitely quacking it up.

    ReplyDelete