BUDGETING

Part 1—Overview

Every nonprofit journeys along the path it presents in its mission and vision statements. Although the organization’s true planning horizon is more expansive than just a twelve-month period, each fiscal year is a milepost along the way, and the notion of the fiscal year is deeply ingrained in the operational and financial structures that all nonprofits live by.

The annual budget provides the “map” which guides the nonprofit on its journey. I think of the budget as an operating plan arrived at through the efforts of board, management, and staff. Each year management pulls together the fruits of these labors into a document that lays out the goals for the next fiscal year, specifies the financial resources that will be used to meet those goals, and offers backup plans as a hedge against unforeseen events.

THE PLAYERS

The Board

In their role as volunteers charged with governance, the board works in partnership with executive management to continuously refine and develop the organization’s vision for the future. Strategic planning initiatives form the bedrock of the budget in areas such as:

  • New programs
  • Infrastructure upgrades to technology, facilities, and human resources
  • Marketing and development
  • DEI (diversity, equity, inclusion) initiatives

Board members are usually not privy to day-to-day operations, but the budget provides the information they need to monitor performance throughout the year. At the moment that the operating plan presentation is approved, management and board have a roadmap in hand that should yield agreed-upon results if followed.

Executive Management

The ED (and the board in some cases) sets budget parameters in operational areas such as:

  • Health insurance plans
  • Cost of living increases
  • Leases and contracts
  • Retirement plan match level
  • Operational policies and procedures

The ED is ultimately responsible for the cost center-level budgets that underlie the big picture numbers that the board will approve. The ED sets the tone that will motivate the staff to prepare these budgets in painstaking detail; the budget will be a critical benchmark (among others) by which the success of each program will be measured.

Program Directors

Every dollar in the budgets of individual programs tells of the plans that will guide the activities of the program managers and their staff throughout the year. Formulation of the budget line items that are directly under the control of the program managers will require their time and attention and their commitment to the goals of the entire organization.

The CFO

I call the CFO the “Budget Director.” Yes, the ED is the decision-maker, but the CFO guides the process every step of the way, always striving for the end product that will meet the goals of the ED and board while respecting the program managers’ challenges and aspirations.

The Finance Department

A typical budget has hundreds (or more) of moving parts, all affecting each other. Finance department staff under the CFO’s direction will wrestle countless calculations into a coherent whole using their skill with software and their understanding of every aspect of the organization’s finances.

PHILOSOPHIES

Surpluses and Deficits

Do we have to budget for a zero bottom line? This is a question that everyone who has ever worked on a budget has asked. Decreeing that all budgets must be balanced is a mistake, and in fact will produce unhealthy results such as unrealistic revenue numbers, unreliable indirect cost allocations, or inequitable personnel policies.

Your bottom line might be a deficit or a surplus. While no one wants a deficit, the entire team from the board on down must acknowledge that hard realities such as chronic underfunding, inflation, economic uncertainty, unfavorable job markets, etc., cannot be willed away in a budget. Board and management will have to work together to agree on the circumstances under which a deficit for either a single program or the total organization can be tolerated.

On the surplus side, conventional wisdom favors budget surpluses that are intended to create or add to reserves. Inevitably, the argument will be raised that funding entities are less likely to fund an organization that reports surpluses. The counter argument, of course, is that all businesses, whether they be nonprofit or for-profit can thrive only when they have the financial resources to face tough times and to maintain and/or modernize their infrastructure—buildings, technology, workforce recruitment and training, etc. Just about every nonprofit expert highly recommends the formation of robust reserves and this can only be accomplished with surpluses. If your organization is able to budget a surplus, lucky you. Go for it!

Payroll Budgeting

Payroll is often the most arduous part of the budgeting process. I highly recommend budgeting by employee. This means creating a worksheet listing every employee, their cost center, their rate of pay, and their fringe benefit cost. Ideally, fringe benefits are itemized on this worksheet, but sometimes you can shortcut that process by applying an average fringe benefit ratio to total salary for each employee.

CFOs struggle with the problem of predicting staff turnover. It is a virtual certainty that staff will come and go during the budget year. Some positions may stay open for many months, creating significant cost savings.

The conservative route is full staff budgeting where every position is considered to be occupied for the entire year. In all but the smallest organizations this is guaranteed to create a cushion because there will be turnover. The size of the cushion will vary depending on the organization. Let’s say that ABC nonprofit, a $20 million organization with 300 full-time staff, experiences savings in payroll cost compared to the budget throughout the year of $500,000, or 2.5% of expenses. Come late fall, ABC has the cash in hand to go on a spending spree to replace computers, vehicles, upgrade information technology, make building repairs, etc.

This conservative budgeting approach reduces risk, but it hampers management’s ability to plan and execute projects throughout the year. Equipment and maintenance projects must be received or completed by 12/31 in order to include the expenses in the current year. This can create chaos in the last few months of the year.

I have had some success in planning for staff turnover by including a “vacancy factor” in the budget of a cost center that is likely to have turnover. The vacancy factor is a fictional position with negative values for salary/fringe that reduces the payroll budget for that cost center while the budget for each staff position remains intact.

Say you want to reduce your payroll by one FTE in a program that provides case management services. The average annual salary/fringe is $50,000. Your vacancy factor will be a budgeted position with a calculated annual salary of negative $50,000. Each position will be accounted for but the total payroll for that budget will be reduced by $50,000. This is a somewhat risky move that should be used sparingly and only when turnover is highly likely. Beware: This is not just a gimmick to produce a balanced budget. Vigilant monitoring of your budget-to-actuals is always a must, but especially if you have vacancy factors, so you can act quickly if reality is not matching up with your predictions.

There is no perfect solution to the payroll problem; you will have to use your best judgment in choosing your approach. The reality is that budget planning doesn’t end on the day the board votes its approval of the operating plan. Changes, especially in staffing, occur throughout the year and the budget can quickly become obsolete. In addition to budget monitoring, year-end forecasting is a valuable tool for managing operations and taking advantage of payroll cost savings throughout the year. Not all nonprofits do year-end forecasting, but I have found it to be well worth the effort.

Depreciation

The word “depreciation” causes angst for some nonprofit executives. Depreciation is a noncash expense that is required by GAAP (generally accepted accounting principles) on the audited financial statements. For many nonprofits that’s where depreciation begins and ends. Many knowledgeable people, however, are adamant that depreciation must be budgeted and recorded regularly in order to ensure that the cash will be available for fixed asset purchases when it is needed.

Budgeting for depreciation means that you are planning for some portion of the cash you receive during the year to stay in the bank account. For example, ABC nonprofit expects to receive grants and donations of $50,000 next year. $45,000 will be spent on payroll, utilities, office supplies, etc. $5,000 will be recorded as depreciation expense, but there is no depreciation invoice to pay so the cash will remain in the bank. Each year, ABC might transfer $5,000 from the operating bank account to a special purpose bank account that is dedicated for asset replacement. Funds from this account will eventually be used to purchase replacement assets.

The decision to include or exclude depreciation from the budget is entirely dependent on the organization’s circumstances. In certain cases this may be the ideal approach to fixed asset replacement. However, not all grantmakers—private and government—do not recognize depreciation as an allowable expense. If your plan is to budget for depreciation your revenue source may have to be donations and other fundraising revenues.

Some organizations are able to obtain special purpose grant funds to replace assets such as vehicles and computers. In this case, the revenue to cover the expense will come in all at once and it will not make sense to budget for depreciation even though you will have to record it in your audited financial statements.

Another approach to the fixed asset problem is to lease equipment such as vehicles and copy machines, thereby attaining predictable annual cash expenditures. Equipment loans, of course, accomplish the same end.

My point here is that there is far from any one right answer to the question of budgeting for depreciation. Board members from the for-profit world may have strong feelings about depreciation but the CFO needs to carefully analyze the organization’s funding patterns before being persuaded to include it in the budget.

Health Insurance

I have expressed my views about allocation of health insurance at length elsewhere. I will simply reiterate now that I believe that health insurance cost, when budgeted by person, should be calculated as a fixed amount to be applied equally to every FTE in every cost center.

At the program level health insurance is a non-controllable cost; all programs should share the cost proportionally based on number of FTEs, not the actual insurance plan options that employees happen to be using at the time the budget is created. This method solves a number of problems including the impossible task of predicting which plan (if any) that new hires will choose.

See the next article in this series for more on how this is done.

Budgeting is a Key to Success in the Nonprofit World

A budget is a plan—we’ve all heard that and its true! The painful process of prioritizing the use of our resources is a team effort that gets everyone on the same page (literally) from the board of directors down to the line staff. It’s a map for a small stretch of the road before us. We know that that road may develop potholes, but we start out with a thorough understanding of our resources and the demands on them so that we can change and adapt along the way.