Best Practices for Nonprofit Financial Health, Part Three: Understanding Full Costs
In a three-part series on “Best Practices for Nonprofit Financial Health,” Alice Antonelli, Director for Advisory Services at Nonprofit Finance Fund (NFF), shares answers to some of the most commonly asked questions about nonprofit finance along with best practices for financial health in the social sector. Her first post explores the “Top 3 Measures of Financial Health,” the second highlights characteristics of “Smart Business Models,” and this third post unpacks practical considerations for understanding full costs.
What does the term “full costs” mean?
Full costs include day-to-day operating expenses (both program and overhead expenses) plus a range of balance sheet costs for short-term and long-term needs (cash to pay the bills and savings for a rainy day). Nonprofits need to generate surpluses large enough to (re)invest in the organization’s immediate and future health. Actual full costs will vary for every organization, but in general, I like to use this formula to think about full costs:
I’ll use the analogy of a small performing arts center, the Drama Queen (DQ) Theatre, as an example of what full costs might look like at an organization:
- Day-to-day operating expenses: staff, space rental, performer fees, supplies, etc.
- Unfunded expenses (cost of something that would enhance the current budget): the cost of adding extra personnel such as an assistant to the managing director, or a contracted grant writer
- Working capital (funds that cover predictable periods when cash outflows exceed cash inflows): money in the bank to cover operating costs during summer months when programming is significantly lighter
- Reserves (for risk, opportunity, and/or equipment repair and replacement): savings to cover anticipated repair work on their van, and/or to take advantage of opportunities to feature special guest performers (e.g., a last-minute addition to the season’s calendar)
- Fixed asset additions (i.e., property and equipment): purchase of new lights and/or upgrading sound technology
- Debt repayment: paying back principal owed on the equipment loans
When nonprofits budget for their full costs and communicate their full capital needs to funders, they are better able to avoid crises and provide uninterrupted services for their communities. Covering full costs (as both a nonprofit budgeting practice and a philanthropic strategy) will allow leadership to stay focused on mission and outcomes.
But aren’t surpluses negatively viewed in the nonprofit sector? Will having a surplus discourage outside funding?
As suggested above, surpluses are important, not only for adding to savings each year, but also for paying back any debt owed and investing in fixed assets. Surpluses help nonprofits to become more innovative and creative, and are critical for ongoing sustainability. They should not affect ongoing contributed support or outside funding. Part of what we have to do as a sector is educate our funders and other stakeholders to make sure that they understand how important surpluses are to long-term sustainability and adaptability (note - not all funders need this education; many are on board and already know and understand the importance of surpluses). Without surpluses, many organizations barely survive, let alone thrive.
I have heard a lot about depreciation…What is it? And how does it factor into full costs?
Depreciation is a non-cash expense that addresses the use of fixed capital assets (e.g., a building, vehicle, or equipment) over time. Let’s say that DQ Theatre bought a van for $50,000. Instead of recording an expense on the income statement for the full $50,000 when the car is purchased, an accounting entry shifts $50,000 cash from the checking or savings account to fixed assets on the balance sheet. Then, every year, a portion of the fixed asset’s value is recorded as an expense on the income statement. This could be calculated using a straight-line depreciation equation by simply dividing the fixed asset purchase equally over a set number of years expected to be its useful life. For instance, the van that they purchased would deprecate over 5 years, so we would record $10,000 as an expense each year, over the five years.
Say DQ Theatre maintains an operating budget of $600,000 and raises that amount in revenue to generate break-even results each year. A simple way to address full costs would be to add the $10,000 in depreciation expense to its $600,000 budget in order to create a revenue target of $610,000. Essentially, after raising the $610,000 in revenue and spending $600,000 in cash expenses, the organization will have $10,000 left over that it can set aside into a reserve for repair and replacement needs. After five years of this practice (and if the organization does not have to make any major repairs on its van in the meantime) it will have saved $50,000, enough perhaps to replace the van (not taking into consideration inflation or resale of the old van).
Some organizations do not budget for depreciation expense simply because it is a non-cash expense – in other words, no one writes a check to “Mr. Depreciation." In other cases, an organization may feel like cash is too tight to budget for depreciation or it may have a different strategy for addressing its future P&E (property and equipment) needs. For example, an organization may launch a capital campaign every three years that has proven to be historically successful. Whatever the case, depreciation can be a useful budgeting practice.
However, if you run an organization with a significant amount of fixed assets, you may want to consider a more precise tool, such as a Systems Replacement Plan (SRP), for estimating the future cost of facility wear and tear, given that depreciation is just an accounting estimate that may have little to do with actual facility costs year to year. An SRP is a tool in which engineers survey the facility to identify and prioritize any deferred maintenance issues (i.e., the practice of postponing repair and replacement activities), and then create a 20-year savings plan that incorporates the facility’s repair and replacement needs over time. The organization can use this schedule as a part of its annual budgeting process, either by including an estimate of necessary repairs to be made that year, and/or an estimate of how much it should set aside in an equipment repair and replacement reserve for future repairs.
When thinking about full costs, how and where should nonprofits factor in volunteer hours?
Volunteer hours are considered an in-kind donation of services. In-kind contributions represent goods or services donated to the organization, and the value of these goods or services should be represented on the statement of activities (or P&L) as a donation and a corresponding expense. For example, if a lawyer donates 1,000 hours and would have otherwise charged $100 per hour, then the nonprofit should recognize an expense and a donation of $100,000 each. Keep in mind, a lawyer’s rates will be different from an administrative assistant’s rate, or an artistic director’s salary. I encourage all nonprofits to try to capture the hours of all donated material and meaningful services in their budgeting process.
In some cases, it might be leadership staff that volunteer hours for their organization. I worked with a nonprofit where the Executive Director contributed his time. I encouraged the nonprofit to come up with a salary that they thought would be appropriate for him and start including it in the budget. By including it in the budget as an in-kind donation and corresponding expense, the board can begin to recognize the real cost of having an ED and get a better understanding of the organization’s true operating budget and needs.
As you can see, full costs include not only regular, ongoing operating costs, but also items that affect the overall health of the organization. I encourage all nonprofit leaders to consider the importance of, and how to budget for, full costs.
Measures of financial health, smart business models and full costs are all important areas of focus for NFF. I hope that by exploring these concepts through commonly asked questions that I have provided practical advice for nonprofit leaders who are navigating the financial health and management of their organizations.
For more on full costs, check out the following articles by NFF:
- "Why Funding Overhead Is Not the Real Issue: The Case to Cover Full Costs" by Claire Knowlton in Nonprofit Quarterly
- "Grantmaking Should be Grounded in Real Costs" by Antony Bugg-Levine and Fred Ali in Stanford Social Innovation Review