Best Practices in Managing Your Nonprofit Operating Budget
Accurate budgeting is critically important to the success of any business, and especially important for nonprofit organizations that may have stretched resources, fluctuating funding, and/or heavy reliance on specific funders. The operating budget is a key tool in effectively and efficiently achieving the organization’s stated purpose, and should align with your organization’s strategic plan. A well-formulated operating budget allows for best use of limited nonprofit resources and sets the course for the organization.
AAFCPAs highlights for your consideration some best practice recommendations for managing your nonprofit operating budget:
- Assess Key Trends and Ratios – In the beginning of the operating budget process, AAFCPAs encourages clients to “step back” and assess their financial position. Look at key trends and ratios over the last three to five years, including:
- Operating results (“profits”)
- Level of operating reserves (without property and equipment, Board-designated, and donor-restricted net assets)
- What is the number of months of operating expenses in operating reserves?
- Trends in operating results and reserves over time
- Liquidity – such as current ratio, cash trends, and collectability of receivables
- Leverage – such as debt/equity ratio
Ask yourself: “If past trends continue, what will the impact be? If reserves are low, what’s the plan to build reserves?” Determine if any trends need to be course-corrected, and make this part of your organization’s financial plan and budget.
- Use Zero-Based Budgeting – AAFCPAs recommends zero-based budgeting as a good approach to resource and budget planning because it forces reevaluation of all assumptions each year. This involves starting annually from a blank budget and analyzing each program’s expenses for the current budget cycle, taking into consideration the program’s goals and future plans. What are the nuances of each individual program that impact costs, and are their new or creative opportunities to redesign cost structures and add to program efficiency?
- Assess Each Program – Look at the financial trends for your programs over the past few years, and assess if each program is covering its direct costs, or contributing to overhead. If a program is not a “core” mission program and it’s not covering its direct costs, has there been meaningful discussion about the value in continuing the program? If a program is a “core” program, but not covering its direct costs, or not contributing to overhead, have you considered ways your organization may improve the financial results? For example, if a program is not covering its costs, is there a way to develop additional donations specifically for that program?
- Assess Other Important Factors and Risks – Important factors that may affect your organization’s ability to plan effectively and stay on budget may include:
- Potential changes to fixed costs and obligations – Do you have a lease term set to expire which may result in a rent increase? Or, are you re-negotiating a labor contract, which may impact labor costs?
- Revenue concentrations and related risks – Do you have one funder who provides a significant portion of the organization’s support, and a plan in the event that funding were to cease?
- Budget for a Surplus – Your annual unrestricted surplus should be sufficient to meet debt obligations, fund depreciation, and add to operating reserves. AAFCPAs recommends a 3-5% surplus operating budget each year, and 4-6 months of expenses in your operating reserves. A nonprofit must balance its “business reality” with its community purpose and mission in trying to build its reserves. Nonprofits, just like for-profit businesses, must be financially sound. The stronger you are financially, the better you are able to serve your community. Reserves are critical to long term health, and they can indeed mean the difference between surviving a rough patch or being forced to wind down. Budgeting for a surplus allows you to achieve sustainability, and support future innovative projects. Budgeted deficits should be rare and part of an intentional plan with a path toward recurring surplus. There is no mission if there is no margin. Your organization should also think about building different types of reserves, such as stability funds, program expansion reserves, or innovation funds.
- Avoid the “Nonprofit Starvation Cycle” – Look at your organization’s overhead and infrastructure costs, such as necessary IT upgrades on the horizon. The goal is to avoid the “nonprofit starvation cycle” of never having enough to invest resources in infrastructure, or having overhead that is “too lean” to effectively run the organization.
- Build Budget Buy-In and Ownership – A budget is a “marriage” between your program and finance teams, as well as development. The annual planning dialogue between finance, development and program managers is a great way to increase organization-wide accountability, expand financial understanding and enhance buy-in. Additionally, AAFCPAs encourages clients to seek value and accountability from their Boards in the budget process. Your Board’s involvement in development and approval of the budget is the cornerstone of board financial oversight, and sophisticated nonprofits proactively bring the board’s knowledge and leadership into the budget process.
- Monitor the Budget Throughout the Year – Budgets are too often proposed, discussed, accepted, and forgotten. A well-managed nonprofit will have a clear understanding of budgeted versus actual, and what caused the difference. Budget ownership and good communication between the program, finance, and development departments and the Board are key to monitoring the budget during the year. Once the budget is established, consider it somewhat binding, with all team members agreeing to work within the plan and avoid reforecasting. When your organization is not in line with the budget, you should look at “why,” and what factors you can control or change.
- Budget for the Long-Term – AAFCPAs encourages clients to develop a long-term operating budget that goes out for the next three to five years. This longer-term budget can be a helpful tool in thinking about your organization’s long-term financial plan and should be closely aligned to the strategic plan.
A comprehensive annual assessment of your organization’s financial picture, program costs, and overhead will put you in a better position to develop a realistic budget and sound financial management.
AAFCPAs provides practical guidance and best practice recommendations so nonprofits may proactively plan for sustainability, and preserve their capacity to deliver on their missions in the event of unforeseen financial shortages. If you have any questions, please contact your AAFCPAs partner, or Janice O’Reilly, CPA, CGMA at 774.512.9046, firstname.lastname@example.org.