Balancing the Mission Checkbook

It’s been gratifying to hear and read the great feedback about An Executive Director’s Guide to Financial Leadership published in the current issue of The Nonprofit Quarterly. I enjoyed writing the article with co-author Jeanne Bell from CompassPoint Nonprofit Services. We have very similar approaches to finance as a tool for mission and community impact. Nonprofit managers and directors have posted online comments and given me direct feedback that they appreciate the practical guidance that goes far beyond bookkeeping basics. These principles help to build strong infrastructure and capacity, and break some habits that aren’t serving our organizations very well.

I encourage you to read the full article (and subscribe to the magazine!)  Here is the brief “Executive Director’s Finance Cheat Sheet” of the eight key business principles that we believe are essential for financial leaders.

1. Develop your annual budget with a commitment to its net financial result—whether surplus or planned deficit—and then adjust spending during the year if income is not coming in on pace to yield that net result. Then, complement your annual budget with rolling financial projections that incorporate your most current information about probable future financial results.
2. Diversify your income cautiously, ensuring you have the capacity to develop and sustain the programmatic and operational requirements of attracting each new resource type well.
3. Develop cash flow projections along with the budget and rolling projections so that you can anticipate any cash flow problems well in advance, when you have more options.
4. Plan goals for financial reserves based on your typical cash flow cycles and risks and incorporate reserves into all financial plans and policies. Be sure to foster a financial culture for staff and board that understands the importance of a regular operating profit or surplus.
5. Pursue restricted funding from those foundations and corporations that understand and value your organization’s mission and particular strategies for achieving impact. When pursuing restricted funding, develop proposal narratives and accompanying budgets that link staff development to program design to superior outcomes, including all related costs as direct.
6. Ensure that your finance function is always properly staffed; if necessary, use a mix of staff and expert contract consultants to achieve this.
7. Discuss expectations for financial roles and responsibilities with board leadership to create accountability and information flow that matches the size and life stage of the organization. Make sure to invest time to develop meaningful financial report formats for the board that reinforce organizational strategies and goals and supports the board in fulfilling their responsibilities.
8. Introduce the concept of enterprise risk management to your team and initiate an internal assessment of a full range of risks.

Read the article and let me know what you think and what other principles we should add. For those of you in Minnesota, we’ll have a chance to hear directly from Jeanne Bell at a conference coming up in April that Nonprofits Assistance Fund is co-hosting with Minnesota Council of Nonprofits. Watch for more information soon!

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!

Nonprofits Assistance Fund regularly gets inquiries from nascent nonprofits seeking help in getting their first round of funding to begin their work. Some come to us because they believe our name means we can give them a grant (we can’t) or that we can help them with a loan (for an organization without a financial history, we can’t).

Here are some sound ways to begin bringing in money and other resources, such as volunteer time and gifts-in-kind.

1. Start with a budget.  Your budget communicates your plans and tells prospective donors and funders how realistic you are in your work.  A start-up budget is likely to be very modest with minimal staff and facilities. This checklist can help you begin, but keep in mind your first year expenses may need to be very limited to show you understand how to start from the beginning and not take short-cuts. If you have a reasonable plan, supporters are more likely to bring dollars to the table than if you only have good intentions without a roadmap.
2. Your founding donors probably know you.  Covering the first few expenses (even filing the IRS form costs money) has to come from somewhere. People who already know and trust you will be your strongest supporters. Have a party to explain your mission to friends and family, and ask them to help cover the initial costs. Nonprofit founders often stand alone for too long, and paying all the expenses out-of- pocket can cause a lot of stress early on.
3. Think small. Many nonprofits want to request a large grant right away. The big request is much more likely to be successful if you can show a track record at little achievements. There are many local businesses, houses of worship, and community groups which could afford $100-$500 donations if they see a budget and some initial investment from a start-up organization (see 1 and 2 above).
4. Be wary of debt. A loan or a credit card advance can seem like a good way to get the ball rolling, but often this start-up debt can hobble an organization for years to come. The money you get in earnings and donations in years 2 and 3 are going to be needed respectively. Spending income to pay off debt from the first year can significantly impact an organization’s financial situation down the road.
5. Plan long-term. That big foundation request mentioned in number 3? Don’t forget about it completely. Be ready to show how it becomes viable in year 2 or 3 for your new organization. Start looking at funding cycles, timelines, and begin meeting with philanthropic staff. This, along with proven results, will help you get that first application in on time and ready for approval.

Patience is not only a virtue; it is a key to becoming a thriving nonprofit. Take your time, spend within your means and then plan to grow. Since starting from scratch requires time, resources and money, we emphasize how important it is to plan and budget accordingly. Every mighty oak must start as an acorn. If you are expecting something different, make sure you weigh all of your options.

A large percentage of nonprofits view their strategic plan as an essential part of managing the organization. The process of developing a strategic plan clarifies the purpose of the organization in a mission statement, and gets the staff and board on the same page by setting goals and priorities. The most commonly used tool for financial planning, on the other hand, is the annual budget. For many nonprofits, the financial goal represented by the budget boils down to this: “we hope we can raise enough money to pay for programs and overhead this year. We’ll work really hard to get this done.” Unfortunately, that’s a lousy way to plan.

What nonprofits need is the financial equivalent of the strategic plan that sets goals for programs and organizational development. This kind of financial plan is not for one year. It includes big goals, a clear path to accomplish goals, resource and capacity needs, and benchmarks for monitoring progress. Just as the process of strategic planning brings everyone together to set goals and sort through options and priorities, developing a strategic financial plan reveals the strengths and weakness of the current financial structure and sets goals that are more than annual revenue targets. What’s the right cost structure for delivering programs with measurable impact: paid staff, volunteer, intern, national service corps? These decisions will determine program, management, and financial structure. This idea is illustrated well in the article about Nonprofit Business Model Statements published on Blue Avocado last year.

Most nonprofit strategic plans that I’ve read give limited attention to the financial structure that will be needed to be successful. Some include some projections in an appendix, but most include a short set of financial goals such as “increase fundraising”, or “implement new individual donor program.” Our resource article Transforming Nonprofit Business Models describes the four components of business models: mix of revenue sources, cost of effective programs, infrastructure, and capital structure. A strategic financial plan needs to address each inter-related element of the model both now and what will be needed for the organization to achieve its goals over the next three to five years.

The steps followed in developing a strategic plan include agreeing on the vision and mission, gathering internal and external information to assess community needs and organizational capacity, establishing three to five year goals, and describing more specific objectives for implementing the plan. Strategic financial planning requires similar steps:

• Agree on a vision for financial sustainability
• Analyze financial history and trends
• Conduct a SWOT assessment of the business model
• Identify the current business model
• Evaluate the financial requirements to fully implement the strategic plan
• Assess the external community and market drivers and internal capacity for changing the financial structure
• Describe the business model that will be needed in five years
• Create a three to five year implementation plan

Strategic planning needs the commitment and participation of many skills and perspectives from inside and outside the organization. In the same way, strategic financial planning requires technical expertise for analysis and projections, strategic thinking about structure and alternatives, and creativity to weave together vision, mission and business models.

I’ll be presenting a more thorough session on the need for financial strategy and strategic financial plans at United Front 2011 on Thursday morning. This is going to be a great conference with lots of bold topics about strategy, leadership, and impact. Join us if you can!

Personnel costs are the number one expense for most nonprofit organizations. Many of our clients have made some very difficult choices in the last few years to reduce expenses, including reducing staff, cutting wages or eliminating some benefits. These emotionally-difficult changes can have serious impacts on services, but may be necessary for the long-term health of the nonprofit.

The second-largest expense in most organizations is spent on rent or mortgages and related costs.  Facility expenses can sometimes evoke nearly as much emotion as staff costs, but often generate less examination and conversation at the board or community levels. In tight times, there are some critical issues to keep in mind when thinking about space.

• Your space can impact your mission and vice-versa. Some organizations are very tied to a neighborhood or even to a specific building. Planning for the costs to stay in an area is a priority for some organizations where others may be less tied to a community and could move for less-expensive rent. If you are restricted to a space (through a long-term lease or ownership), changes in your community over time may force your mission and programs to shift.
• Ownership isn’t right for everyone. Many nonprofits consider the idea of buying space as a great way of locking in costs and gaining equity over time, but owning real-estate requires a different set of commitments and management, and can distract from mission-related questions. Buildings may even lose equity if the organization doesn’t reinvest in the property (ask us about funding depreciation in your reserves policy!).
• The costs of a move can outweigh the costs of staying put. A five-percent increase in a lease may seem unbearable in a market with lots of vacancies, but if your nonprofit can make the decision to move, it’s best to understand all costs involved. Compare your current costs against the prices of moving. Think about all the additional expenses that add up such as running new phone lines and data cabling which can consume potential savings. To help you plan ahead, IFF offers nonprofits templates to consider costs for your current space, future space, or a move.

Many other factors can impact what is the right space at the right time for your organization and your mission. Join us at the Minnesota Council of Nonprofits Annual Conference for a break-out session on facilities costs. We’ll be joined by brokers from Northmarq to talk about professional representation in space decisions. Sneak peek: your landlord will often cover the costs of your broker to get professional advice without breaking the bank. Stay tuned — learn more ways to cut down on facility costs at the conference!

Some choices that nonprofit leaders have to make are really tough. Others are tougher. Right now, there are many nonprofits in Minnesota that need to make some of these choices in the next few weeks because of the strong possibility of a state shutdown. In the recent post When the Worst Case Scenario is Really Soon we advised all nonprofits that rely on payments from the state to start working on cash flow contingency plans. As reports are trickling in about notices and conversations with grant and contract managers at state agencies, it’s clear that these plans will need to go beyond cash flow. That’s when questions go from tough (can we pay the staff and bills?) to tougher (can we continue to provide services in our community?).

State agencies are developing their own plans to suspend operations if necessary, and they are dealing with uncertainty just like the rest of us. Many state grant and contract managers are contacting their nonprofits contractors to alert them to possible disruptions in payments or the risk that any services provided during a shutdown may not be eligible for retroactive payment. How much impact would a state shutdown have on your organization, and what kind of plans to you need? The answer (as always) is “it depends”. This very fluid situation demands multiple versions of “what if … “

• What if … a state agency pays funds to the nonprofits from a source other than the state general fund budget, including federal funds or a designated source? A worst case state shutdown could either stop or slow down payment processing of contracts and grants – you need to create a conservative cash flow plan.
• What if … the nonprofit has a long standing state contract or grant? Even with an active contract or grant, a shutdown would stop payments for the near term, and could cause a longer payment lag due to backlogs and other disruptions. Review the contract terms, or check with the grant manager, to confirm whether or not payments are certain for services provided during a shutdown. You need a plan for cash flow delays including both immediate term and some lag time.
• What if … the nonprofit has an established contract with the state that is signed annually with a start date of July 1st or later? This situation poses more risk to the nonprofit because of uncertainty whether a new budget will include a provision allowing retroactive contracts. The budget passed in July 2005, the time of the last shutdown, included such a provision (thanks to Minnesota Council of Nonprofits). You need to take this risk into consideration as you plan – is this a cash flow delay, or a possible loss of some revenue? Could your organization absorb the reductions if you provide services without retroactive payments?
• What if … the nonprofit has a new state grant or contract that begins July 1st or later, or is waiting for a final approval or announcement for state funds? These funds are at the highest risk as long as there is not a budget in place. Be very cautious about assuming that the terms will be untouched and retroactive once a budget is in place.
• What if … your nonprofit doesn’t rely on state funds, or receives small amounts from the state? Rather than feel relieved, think about the impact a shutdown may have on your clients, other organizations with whom you partner, and other community services. You may see a ripple effect in new requests for service, higher demand, or service disruptions elsewhere. Spend a little time brainstorming how your organization might be affected and how you could respond.

The what ifs could go on and on. The only way to answer any of them, and many nonprofits have more than one state contract or grant, is to systematically review the terms, check with grant managers (while they’re still available) and consider the options. In some cases, the options may fall into three categories: tough, tougher, and toughest. The Minnesota Council of Nonprofits is communicating policy information, news, and resources through email and a page on their web site. Nonprofits Assistance Fund is working with MCN to sponsor six free Government Shutdown Emergency Briefings around the state that will include background of how we got to this point, crisis communications techniques, financial planning, and open discussion with your peers. Register through the MCN web site.