Balancing the Mission Checkbook

Nonprofits Assistance Fund advises its clients to think about financial statements as a way to tell the story of their nonprofit missions. How organizations raise resources (mixes of earned and donated revenue, for example), where they spend money, and what they impact as a result of using resources are the narrative arcs of your financial statements.

The stories are told within a common context. Narratives have rules of grammar, and the financial statements have rules about how we describe resources so we all have a common understanding. These rules (Generally Accepted Account Principles, or GAAP) are periodically reviewed and revised to help make sure we are all still speaking the same language, so our stories are well understood.

Someone has to keep the rule book, and in the case of GAAP, that is the Financial Accounting Standards Board (FASB). Nearly two decades ago, FASB changed the nonprofit rule book, because the stories being told under the old rules were sometimes confused tales the average reader couldn’t always decipher. Rules about how we account for temporarily restricted net assets and more were revised to make things a bit clearer. FASB has had more time to see the stories unfold, and the nonprofit sector has now grown more mature, and it’s time once again to think about how these numbers tell our tales.

FASB is considering changes to net asset categories. The specific changes are not final, but it reflects some thoughts Nonprofits Assistance Fund has been promoting with clients. Nonprofit net assets – what you are worth when you take away everything a nonprofit owes from everything a nonprofit is worth – can be described in better detail and with more narrative heft than just whether the asset has a donor-imposed restriction. A single lump of resources at the end of the day is useful information, but showing board-designated categories within the larger context of net assets helps convey intention about the direction and thoughtfulness of the management over time.

Board-designated categories can come in different flavors depending on the needs of the organization and story it may tell. A group with a building or other expensive fixed assets may want to show a designated reserve for repair and replacement work. A nonprofit with significant ups and downs in cash flow may want to show a specific board designation for a cash-flow management account. A nonprofit considering a merger or acquisition may need to show a designated reserve for one-time expenses related to growth.

Each case will vary, but a few well-chosen designations will help your nonprofit story gain understanding – and therefore more support – with audiences. FASB may soon change the rule book, in which case nonprofits will want to align their narratives with the new guidelines. Stakeholders will appreciate the added information, and designations can help nonprofits keep on their strategic targets. After all, when we tell our stories to others, we hear them again ourselves.

We give lots of business model advice to our clients. It often takes a general form, such as, “improve the financial performance of this program” or “better align that profitable program to your mission.” However, sometimes a more technical analysis is required to really understand how to make a business model work.

Every nonprofit business model has unique business model drivers. These drivers are typically income-generating activities that have a significant impact on an organization’s ability to simultaneously operate at a surplus while achieving its mission. Common examples of business model drivers include: number of clients served, number of projects completed, and amount of grant funding secured. Knowing your business model drivers is essential to managing financial sustainability.

These drivers often consequently correspond to the triggers within scenario budgets.  A scenario planning trigger is a decision point at which an alternative budget scenario is implemented. For example, “if we aren’t at 200 clients served by June 30, we need to switch to our Plan B budget and corresponding expense reductions.” Or, “if contributed income is 20% greater than budget at mid-year, we can consider moving to Plan C and implementing our program growth plan.” Scenario budget triggers are critical, because in a changing environment, action is almost always necessary. (For a scenario planning spreadsheet template, check out the ‘Budgeting and Planning’ section of the Nonprofits Assistance Fund’s resource library.)

Setting the appropriate scenario budget triggers requires a good understanding of an organization’s business model drivers. Nonprofit leaders often wonder, “How exactly do I make this budget work?” Or, in other words, “What is the optimal level of service for our organization?”

The rest of this post will explore how to apply a break-even analysis to a nonprofit business model. A break-even analysis tells us at what level of service we’re able to achieve a net financial result of zero, or break-even. We’re going to get technical and do some math. And, it’s going to be fun and helpful in understanding our organization’s financial health!

Let’s first start with some definitions of concepts and terms key to our example:

• Q – Quantity. This represents the number of clients served.  Depending on the business, it could also represent a unit of production.
• CI – Contributed Income. These are subsidy dollars, such as grants and individual contributions, that do not vary when service levels change.
• EI – Earned Income. These dollars vary in direct proportion to the number of clients served.
• P – Price. Synonymous with variable income, this is the amount of revenue we receive for each client served.
• FC – Fixed Costs. These expenses do not at all vary with the number of clients served. For example, if we pay $1,000 in office rent, that expense line-item won’t change if we serve 50 or 60 clients.
• VC – Variable Costs. These are expenses that vary as the number of clients served varies.

Nonprofit budgets often depend on achieving a certain Q. That is to say, at what level of service does our business model work?

A key premise is that a sustainable organization or a sustainable program operates at a financial surplus.

Sustainability = Surplus

Surpluses occur when:

Income > Expenses

Using the above definitions, we’ll think about nonprofit income as either contributed or earned:

Income = CI + EI

Also using the above definitions, we’ll think about expenses as either fixed or variable:

Expenses = Total Fixed Costs + Total Variable Costs

 So, to achieve a surplus, contributions plus earned income must be greater than fixed costs plus variable costs. We’ll call this our Sustainability Equation:

CI + EI > TFC + TVC

Earned income depends on our variable income and the number of clients served, and our variable expenses depend on the cost per client and the number of clients served:

CI + (P*Q) > TFC + (VC*Q)

Since the purpose of this exercise is to find out what service level makes our budget work, we can do some algebra to solve for the variable Q.

CI + (P*Q) – (VC*Q) > TFC

Q * (P-VC) > TFC – CI

Q > (TFC – CI) / (P-VC)

Now we have a useful equation!  To put the analysis to work, we first need a good understanding (or a good guess!) of the following variables: Total Fixed Expenses, Contributed Income, Price, Variable Costs.

Let’s apply the formula to a simple example to illustrate the analysis.

All Services Nonprofit gets reimbursed $500 for each client served. Current staff has the capacity to serve more clients, so the only variable expenses of adding a client are $100 in transportation expenses.  Most of the budget doesn’t change with the addition of a client; we have fixed expenses of $500,000. The organization expects $300,000 in contributed income next year. How many clients does All Services need to serve to achieve a surplus?

Q > (TFC – CI) / (P-VC)

Q > ($500,000 – $300,000) / ($500 – $100)

Q > $200,000 / $400

Q > 500

The budget breaks even when 500 clients are served. If more than 500 clients are served, and all of the other assumptions are accurate, a surplus will be achieved. This is true because there’s a positive margin per client, so that 500 is a minimum quantity.

For some nonprofits, there is a negative margin per client, meaning that costs per additional client exceed revenue per additional client. In those cases, the quantity that the above analysis yields is a maximum not to be exceeded. Serving too many clients would lead to a budget deficit.

In the short term, we work hard to achieve the service level that makes our business model work. But, what if we can’t achieve this level of service? Let’s think back to our sustainability equation:

CI + EI > TFC + TVC

As soon as we suspect that our earned income won’t make its budgeted goal, it’s time to consider alternatives such as increasing the price, increasing contributed income, or decreasing expenses. (This highlights the important point that fixed expenses aren’t necessary inflexible expenses. All expenses should be considered flexible to some degree.)

Nonprofits Assistance Fund’s scenario planning template can help you to imagine what different levels of income and expenses would mean for your bottom-line.

For almost all nonprofits, service level is a key business model driver. It’s important to understand in which direction it’s driving your organization!