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!

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!

Brad Kruse, Program Director at Hugh J. Andersen Foundation with Steve Boland, Nonprofits Assistance Fund

The Minnesota Council of Nonprofits’ Minnesota Foundations 2012 conference was another info-packed afternoon, talking about all the news from the latest edition of the Minnesota Grants Directory. Hundreds of grant-seekers gathered to share what they know about philanthropic support in Minnesota, and occasionally to bemoan how funders just don’t get us.

The conversation shifted to ways nonprofits can help granters. One suggestion was to add a good narrative to budgets or financial documents. Financial narratives are brief comments that can accompany grant proposals and can be extremely helpful for potential funders. Nonprofit organizations that use financial narratives have the opportunity to explain unusual or exceptional circumstances and avoid any potential confusion or misunderstanding.

Some possible situations to explain in a financial narrative:

• Is there anything in your document that would stick out as unusual for the first-time reader?
• Are there any unusually large or exceptional sources of revenue requiring explanation, such as receiving a planned gift or one time grant?
• Explain if your organization received a multi-year gift that will be recognized all in one year and expended over multiple years. A simple sentence or two can go a long way in explaining an unusual surplus in one year and then deficits in one or more years after. If applicable, be sure to report temporarily restricted income and explain the restriction.
• Does your organization have an internal, board-restricted reserve or other internally restricted funds as opposed to having cash on hand? If so, does your board have a cash reserve policy? Explain cash reserves and any policies in the narrative.
• If your organization has a deficit or multiple-year deficits, put the situation in context and use the opportunity to explain what the organization is doing to address the situation.
• If your organization has a healthy balance sheet with surpluses, put the situation in context and explain your need. “Why not spend down your resources before seeking more?” You likely have a good answer. Write it down.
• Explain if the special event revenue line. Is this one special event or the totals from several special events?
• Does your individual giving contain special events or are those listed separately?
• Large amounts of in-kind contributions can raise questions. Provide some detail that explains how these donations fit the guidelines for in-kind contributions.
• Does your program budget contain all committed funds or only partially committed funds and the plan(s) to raise the necessary funds?

Obviously, not all of these questions are appropriate for every situation and financial narratives should be kept brief. A financial narrative that goes on for pages and pages is usually not as helpful. A brief, one-page or less narrative can be an important tool in helping your organization tell your story and make your case.

How much are you willing to pay for a ticket to the theater, a management class, or a counseling session? What should other patrons or clients pay for that same service? Does it matter to you whether or not the price that you pay covers the actual costs of receiving that service?

The rapid changes in the availability of government and philanthropic funds to pay for and subsidize services have led many nonprofits to examine their financial structure and realize that they can’t afford to continue to offer their services for free or nearly free. That model may have worked when the grants and contributions were available, but it doesn’t any more.

Nonprofits Assistance Fund offers workshops and webinars for staff and board members of nonprofits on financial management topics. We charge a fee for these training programs. What’s the right price for us to charge? Change the specifics and that same question is being raised at nonprofits of every size and scope. The answer, as with everything, is “it depends.”  It depends on the purpose and goals, both programmatic and financial, of offering the service. Should prices be based only on costs, or does market demand factor in understanding what your clients or audience are willing to pay? Some of the fee-based services offered by nonprofits are more naturally based on market and competition. Others are much more sensitive to the ability of clients to pay. Theater tickets and tutoring for low-income students have different economic models.

When you start this analysis, it’s important to recognize that discussions about starting to charge a fee or making changes to prices often get caught up in emotions about money and organizational and personal values. When the suggestion of requiring a payment from clients first comes up, expect some of your colleagues to recoil in horror. Someone may even tell you that nonprofits are not legally allowed to charge for their services. (Please tell that to the two colleges that I’m currently supporting!) Talking about money is uncomfortable for many people, and offering services for no charge is very easy. Unless you have adequate subsidy dollars from contributions or other sources though, it’s not sustainable.

A recent post on the Stanford Social Innovation Review blog, Nine Tips to Better Nonprofit Pricing, provides a good start with the market approach. I highly recommend the article To Fee or Not to Fee?, published in the Summer 2004 issue of Nonprofit Quarterly for a thorough review of whether or not to charge a fee, how fees and program access can be aligned, and how to set prices. The article makes a strong case that charging fees improves the relationship with clients:

The most powerful argument in favor of charging fees is the discipline of the marketplace – that fees increase accountability to the people receiving services.

They include a summary of research that showed that fees may help clients buy-in to the services more and perceive greater benefits.

For most nonprofits, charging fees and setting prices will depend on a number of factors, but most of these can be addressed with operational capacity, program design, and differential pricing. This topic is worth a thorough review whether you currently charge fees or not as a part of long term financial planning and strategy.

Now that most nonprofits have filed the new version of the IRS 990, you might be taking a deep breath of relief that you got that big change done with and over. Don’t let the 990 sit in a drawer, though. Not after all that work. The new 990 is a big step forward to bring better, more usable information to a wide range of stakeholders including current and prospective donors, watchdog groups, public officials, media, and other nonprofits. Ultimately, the most important user of your 990 is you.

Part of the value comes when you pull together all the pieces to have the form completed. The new 990 requires information about mission, program accomplishments and costs, board members and key staff, policies and governance practices, compensation, fundraising, finance, and much more. While many nonprofits rely on their audit firms to complete the 990, most of the required information is not financial and must be supplied by various departments or staff of the organization. The second part of the value comes from continuing to use the 990 as a communication and analysis tool. Here are four suggestions.

As an organizational tutorial

Read the whole 990, front to back. New managers, board members, emerging leaders, or anyone else on staff who wants to know more about the organization can get a complete overview of the organization by reading the complete form including all of the schedules. This assignment will also help you identify any questions or sections that need to be clarified or completed more thoroughly.

As a financial analysis tool

The 990 contains a complete financial report in a standard format. The new form expands the financial information, particularly the income section, to provide more complete data. Most financial analysis steps can be conducted using the 990. To make it easier, Nonprofits Assistance Fund created a new tool that we call the “990 Decoder.” Transfer the three financial pages from the Core Form onto this spreadsheet and you will generate a familiar looking Balance Sheet and Income Statement and a page of six standard nonprofit financial ratios. These can easily be used for comparison with other years or with other, peer nonprofits. Just “decode” their 990, too. We’re happy that the Minnesota Council on Foundations likes to decode 990s, too.

As a source of comparable compensation data

A month ago we were fielded a number of requests for help from board members of nonprofits who were responsible for obtaining information about executive director compensation from comparable organizations. In many cases, salary surveys fit the bill, such as the thorough review that Minnesota Council of Nonprofits compiles. Another simple approach is to create your own peer group of 4 or 5 nonprofits that are of similar size and type of service. Compile a custom comparison by using Guidestar to collect compensation data from your peers’ IRS 990s. Compensation is usually listed in Part VII on page 7. Guidestar registration is easy and free for the basic search. The information will be at least a year old, but as we told the board members we talked with, no one got much in the way of salary increases last year anyway.

As a communications tool

One of the unique features of the 990 is the Program Accomplishments section that is now the second page of the form. Hopefully you have taken advantage of the opportunity to communicate specifically what activities you completed, who you served, and how this work had an important impact in the community. Take an hour or so and read the Program Accomplishments for your nonprofit and then read the section for a few other organizations that you admire. How well did they communicate their work? How did you do? Learn from other organizations and look for ways to promote your 990 as another communications tool. Post it on your website (along with you audit, please).

Don’t let the IRS 990 sit around gathering dust. Give it a workout and help both your organizations and the nonprofit sector show the value of transparency and accountability.