As we enter the fourth quarter of the year – the “busy season” for most nonprofit organizations – nonprofit executives understandably are focused on meeting their fundraising objectives and finishing the year well. While obtaining grants and donations and having successful fundraising events are extremely important, it is also critical to focus on the next year’s budget at this time of year. Most Executive Directors are already thinking about next year and what they want the organization to accomplish. This requires planning and budgeting. September’s Topic of the Month dealt with Strategic Planning for Nonprofit Organizations. This month’s topic will cover the budgeting process.
The basic questions at the heart of the nonprofit’s budgeting process are:
- What does the organization plan to achieve or accomplish next year?
- How much will next year’s planned accomplishments cost?
- Where will the organization get the money to pay for it all?
While the basic notion for a nonprofit organization is “if it’s not in your budget, you can’t spend it,” it is equally true that “if you can’t fund it, it (the expenditures) shouldn’t be in your budget.”
This Topic of the Month will address the annual budget – purpose and process, types of budgets, and review and use of budgets in decision making.
A budget is a useful planning tool which will enable an organization to meet its goals for the year. The budget provides guidance to the organization on where the money will come from and how it is to be spent during the year. However, a budget is only effective if it:
- Contains well-defined goals which align with the long-term strategic plan,
- Is developed based on sound assumptions and accurate financial information,
- Has appropriate input from the relevant constituent groups within the organization at all stages of development,
- Is communicated throughout the organization, and
- Is prepared on a timely basis and monitored regularly throughout the year.
The nonprofit’s budgeting process, including the roles and responsibilities of the Board and leadership team, will vary depending on the size and structure of the organization, culture, scope of operations, and sources of revenue. The annual budget is the responsibility of the Executive Director and the Board of Directors. The Executive Director is responsible for the timely preparation and accuracy of the budget, implementation and communication of the budget, and monitoring and reporting actual financial results versus budget to the Board. The Board must review and approve the budget, ensure that the budget is aligned with the organization’s mission, policies and strategic plan, and that the budget is financially and legally sound.
In a small nonprofit organization, the Executive Director will prepare the budget in conjunction with the Treasurer of the Board of Directors and with input from key individuals. In larger organizations, the Executive Director (or President, or CEO as the case may be) will delegate the coordination of the budget process to the CFO (or financial manager), and involve the leadership team and all departments in the budget process.
Types of Budgets
The main types of budgets are generally operating budgets and capital budgets. Organization-wide operating budgets are used for nonprofits with many programs and activities. Operating budgets for specific programs are used for small nonprofits with only one program or activity, or for individual programs with specific or designated funding sources in larger nonprofits. Capital budgets generally are used for large, one- time capital expenditures, facility improvement or renovation projects. Regardless of the size or structure of a nonprofit organization, cash flow budgets or projections should be used for effective cash management of the organization.
Generally, organizational operating budgets are developed from either the “top down” or “bottom up” or some combination of the two. Regardless of the approach to budget development, it is important that the process and timetable for budget development is clearly defined and clearly communicated throughout the organization to avoid confusion, inaccurate information and inefficiencies.
Top Down Approach
The top down approach to budget development usually starts with Executive Director and leadership team setting revenue and expense targets (or goals for outcomes and related performance measures) for the whole organization as well as for the individual programs, departments or units. Each program, department or unit will then develop their respective budgets based on the targets provided or the specific goals outlined. The organization-wide operating budget will be comprised of the separate budgets for the programs or departments, with the Executive Director and leadership team resolving any issues or conflicting budget information to arrive at the final budget. It is important that the budget information is both qualitative and quantitative. Numbers are meaningless without the narrative explaining the rationale behind the numbers.
The top down approach is often necessary for efficient budget preparation for small nonprofit organizations. However, careful attention should be given to the underlying assumptions used in the preparation of the budget. If a budget is created simply based on historical numbers and the view of a few people in the organization, you may be building last year’s mistakes into next year’s budget.
Bottom Up Approach
The bottom up approach to budget development will start with each program, department or unit preparing draft budgets that comply with the general guidelines provided by the Executive Director and leadership team. Several draft budgets would be prepared based on variations of the underlying budget guidelines or assumptions. For example, programs or departments may be asked to develop budgets based on assumptions related to level of activity, different scenarios, or other factors. Generally speaking, while an optimistic best-case scenario and a more conservative worst-case scenario are important to framing a budget, using the best estimate of most likely outcomes for revenue and expenses allows for a budget that includes controlled growth.
The most effective bottom up approach to budget development is Zero-Based Budgeting (ZBB). The premise behind ZBB is that no costs or activities should be automatically included in the budget simply because such costs and activities occurred in the past. It is important to examine and justify all programs and activities to determine if they align with the mission and vision of the organization, operate effectively, and yield desired and measurable outcomes. Questions to be considered are whether the program or activity should be continued, modified, replaced or eliminated. All program, department or unit ZBB budgets roll up into the organization-wide budget. The Executive Director and the leadership team will resolve and reconcile any issues to balance program and operations with expected revenue for the period. Compromise and adjustments are usually required.
ZBB does involve some organizational “soul searching” and may be too time-consuming, costly or complex for smaller nonprofits with limited resources. However, the underlying principles of ZBB are worthy of consideration for all nonprofits.
Capital budgets are necessary when a nonprofit is contemplating significant capital expenditures such as facility acquisitions or expansion, renovation projects, major equipment purchases, etc. The organization may embark on a “capital campaign” to raise the required funds for the capital expenditures, in the absence of sufficient reserves or other financing sources.
Cash Flow Budgets (Projections)
Cash flow budgets/projections are an important component for both operating and capital budgets. The cash flow budget breaks down the timing of cash inflows (revenue) and outflows (expenditures) usually on a monthly basis. This planning tool is useful for the effective cash management of a nonprofit organization. It highlights where potential cash shortfalls will occur so that corrective action can be taken to avoid a cash flow crisis. For example, where program and other expenditures tend to occur evenly throughout the year, revenue is often more seasonal or periodic, resulting in potential cash flow deficits that may have to be covered by reserves or a seasonal line of credit from a bank.
Finally, it is important to remember that, regardless of the approach used in budget preparation, there will always be some tension at budget time between:
- Programs or operations – i.e., the cost of what the organization wants to achieve or accomplish, and
- Development or fundraising – i.e., the amount of revenue to be raised to fund the programs and operations.
A process of “budget reconciliation” is always involved to some extent. While some nonprofits are fortunate to have large endowments from which to draw if expenditures exceed revenues for the period, most nonprofits must fund current year programs and operations through revenue raised in the same year. It will always be necessary to “reconcile” or balance the costs of programs and operations with realistic projections of revenue for the period. Adjustments to timing and scope of programs and operations are usually required until funding sources catch up. The revenue side of any budget always requires careful and realistic consideration as to source and timing – thus the notion “if you can’t fund it, it shouldn’t be in your budget.”
Budget Review and Monitoring
After the budget is finalized, it is presented to the Board of Directors for review and approval. The approved budget should then be monitored on a regular basis throughout the year and compared to the actual financial results achieved. Monthly reviews by the Executive Director and leadership team are necessary to manage financial and operational performance. Likewise, program and department heads should receive monthly reports on actual versus budgeted amounts for their area of specific responsibility. It is important that these reports are accurate and timely, to assist management in making appropriate decisions and taking corrective action to address revenue shortfalls and expense overruns as and when needed. Further, in order for management to take effective action, it is important that any deviations or variances of actual financial results versus budget be analyzed and explained.
Remember the budget is a planning tool to assist management in achieving the desired outcomes or goals for the year. It is a dynamic document, a financial plan for the future. Since future events do not always unfold as planned, the budget should be reviewed regularly and may require modifications as conditions change.
Articles for Further Reading:
- Murray Dropkin, Jim Halpin and Bill La Touche, The Budget-Building Book for Nonprofits, 2nd Edition (San Francisco, CA: Jossey-Bass, A Wiley Imprint, 2007).
- Basic Guide to Non-Profit Financial Management. This website provides you with the basic information to keep your non-profit financially healthy. http://www.managementhelp.org/finance/np_fnce/np_fnce.htm#anchor2890212.
- Grant Writing Tools for Non-Profit Organizations. http://www.npguides.org/links.htm