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Jun 21, 2011

Budget balance no indication of sustainability

Here is my June column for Columbus Business First. In this column I discussed the misconception that a balanced budget is a marker of sustainability for nonprofits.

Many nonprofits have been working diligently in recent years to examine their operations and restructure to adapt their mission and services to the realities of community need and resource availability. As I have worked with many of them, I have noticed a number of myths or misconceptions that limit the effectiveness of what they do.

I am continually amazed at the pervasiveness of the notion that budget balance is an appropriate way to determine the sustainability or management competence of a nonprofit. Budget balance is almost always the wrong policy for sustainability. Indeed, requiring annual budget balance guarantees that nonprofits will over-expand when the economy is strong and will have to cut services during recessions.

Contributions and earned revenue rise pretty much in lock step. It is a myth that contributions increase in the aggregate during recessions. IRS data since the early 1980s show that contributions are a virtually invariant share of nonprofit revenue regardless of the state of the economy. That means that nonprofit revenue rises when the economy is strong and declines when the economy declines. A budget balance requirement compels nonprofits to increase spending when revenue is rising and to decrease spending when revenue is falling.

A sustainable nonprofit is one that is a reliable provider of a critical need in the community. A reliable nonprofit will provide its most essential services regardless of the ups and downs of government budgets or the economy. Cutting back during recessions is not being sustainable or reliable. Thus budget balance undermines reliability during recessions.

Ironically, we do not use budget balance as the yardstick for management competence in the for-profit sector. Indeed, in the last recession, virtually no major local for-profit managed to avoid losses at some time. If we want nonprofits to be reliable, we have to allow them to have deficits, too, during recessions.

The trick, of course, is how to make that possible. The answer is to resist pressures to expand services when extra revenue is available. Instead we should encourage, or better, insist that nonprofits run surpluses when the economy is strong and set aside those surpluses to use to support services in recession. Thus, we need to ban budget balance both when the economy is expanding and when it is declining.

What do we need to reconsider? First, we need to drop deficit as a definition of poor management and drop surplus as a definition of lack of need. And we need to use the same criteria for good nonprofit management as we use for good for-profit management. I have never heard a business analyst comment on a for-profit company’s ability to balance its budget.

Second, when the economy is strong, we need to view nonprofits that are running surpluses to be as deserving of our continued support as nonprofits who are balancing their budgets or struggling with deficits. One may caution that a nonprofit with a surplus doesn’t “need” the help. If sustainability is the criterion, the nonprofit that is thinking about and preparing for the next recession “needs” to run a surplus when the economy is strong. This is difficult because the needs of an organization cannot be summarized into a single notion of surplus, balance or deficit. Indeed, a sound multiyear financial plan is an excellent way to determine if the organization is thinking sustainably.

Third, when the economy is weak, nonprofits that are running deficits should not be necessarily penalized. If they have a clear notion of how the economy affects their revenue and demand for services and if they have made sincere efforts to set asides reserves in prior years, they are actually being very well managed.

If they are running deficits because they overexpanded in prior years, they should be encouraged to restructure to find the sustainable level of their key mission activities and to scale back on any money-losing, low-mission activities.

Once again, this is what we would expect a responsible for-profit company to do, where low-mission is analogous to low-margin.

Fourth, funders need to provide nonprofits with technical support to identify the level of reserves they need to accumulate in order to be sustainable and help them to establish responsible rules for contributions and deductions over the business cycle. Multiyear financial planning, “sales” forecasting and balance sheet management are not the skills nonprofits can usually afford to hire. Many nonprofits will need technical training, or loaned executives, to collect and analyze data to understand how their business behaves over the business cycle and to assemble a good governance plan to oversee management of reserves.

Nonprofit board members as well as philanthropists need to understand the arbitrariness of budget balance. As a broken clock is correct twice a day, budget balance is the correct policy only at that transitional moment between economic expansion and contraction. It is a simplistic standard that keeps our nonprofits weak financially and compromises their ability to be there when our citizens most need them.