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Jan 15, 2014

How to Think About Restructuring

Thanks for a great holiday break from blogging.  Now back to the hustings!

A client of mine is struggling with how to improve its financial performance.  The need is pressing since facilities are not being maintained and the board has focused so strongly on annual budget balance that nickel-and-dime cost cutting is becoming  routine and adding money to invest in new programs is slipping off the radar.

After reviewing their finances, three things became clear to me.

First, their GAAP deficits were driven by unfunded depreciation. Net revenue before depreciation was bouncing around zero. This is a non-cash expense which many nonprofits never consider in their budgeting.  This organization does have some apparent plant deterioration so raising operating results to provide resources to cover depreciation (and repair facilities with those additional funds) is appropriate.

Second, there were sharp differences in the rates charged and in the variable costs across service areas. This suggests that shifting the level activity among service areas is an option to improve overall finances.  Not all nonprofits have this option, but this organization has an alternative to expansion or cost-cutting as a path to higher net revenues.

Third, of the over one dozen services it provided, only a handful were viewed as high mission, the rest were medium to low mission, meaning that either the organization was not a unique provider or else the community need for that service was not (or no longer) very high. This is a classic problem addressed by the Linking Mission to Money Grid which is summarized in an excellent article by the Georgia Center for Nonprofits.

It seemed to me an obvious solution:  shift resources from low mission, limited revenue services toward both higher mission services and  the more profitable services.  This can be a two-fer:  provide more high mission services both by shifting personnel from lower-mission activities and by expanding volume in services which had a higher net revenue margin.

But the organization has become bogged down.  In practice this notion of shifting resources to better the overall organization has become entangled with financial analysis that looks at each individual activity in isolation and doesn’t distinguish between fixed and variable costs.  Overhead and depreciation don’t go away when a service is eliminated or cut back because those costs are fixed, not variable costs.  This creates the illusion of smaller savings if the service is eliminated.

One should focus on variable costs in determining the benefits of SHIFTING resources and personnel to other services.  The higher margin service can absorb the fixed costs better than the low margin service.  And by doing so, the bottom line of the entire organization will be better.

But what if it takes up to a year to expand in the higher margin services, won’t the financial problem persist?  Once again it is important to compare alternatives.  #1:  Stay with the low margin and NEVER improve the bottom line.  #2: Shift to higher margin services and IN A YEAR OR SO improve the bottom line.

The only time such a shift is not appropriate is when the low margin service is high mission.  For this organization, this dilemma did not exist:  the targeted lower margin services were not the highest mission services, so the proposed shift would improve financial strength and create the option to enhance higher mission services.

Not distinguishing between fixed and variable costs in making restructuring decisions creates flawed decision-making.  Make sure when you evaluate alternatives you carefully identify between the two.