Reporting and Operations
Budgeting Terms & Concepts
An organization's financial plans should include budgets for both operating and for capital as discussed in previous section, on Budgeting. The budgeting process and good practices were also discussed in the previous sections, The Budgeting Process, and Budgeting Practices. In this section we will discuss the terms and concepts involved in creating the annual operating budget.
The annual operating budget is associated with the Statement of Activities (SOA), sometimes called the Income Statement or Profit & Loss, and involves projecting income and expenses for a single fiscal year to accomplish an organization's immediate mission agenda. The annual budget can be projected over multiple years as part of a strategic plan to include the budget impact of identified strategic initiatives. In building an effective operating budget it is necessary to understand some terminology and concepts.
Approaches to Budgeting
Income Based Budgeting
As covered in the Budgeting Practices section, the most reliable budgets yielding the best fiscal results for the organization are conservative and income based.
- Budget for income first. Base income targets on realistic expectations and only include reliable income in the budget. Never include an income projection that simply fills the gap to cover expenses. This sets the organization up for a budget deficit if the organization fails to hit the "plugged" income targets.
- Ensure expenses are lower than the dependable income total. This requires cooperation among all departments in setting organizational and programmatic priorities, timing new or adventuresome programs.
- What-if scenarios can be proffered: we can do this desired project/program if that additional revenue comes in.
Income based budgeting is my preference; however, there are other approaches to budgeting commonly used by small and midsize groups. Some combination of all of these approaches could be used, depending on the organization's circumstances.
- Incremental budgeting begins with prior year totals, and builds the subsequent year's budget by calculating percentage increases/decreases.
- Zero-based budgeting starts from scratch every year: How much can we raise? How much can we spend? What are the most important mission activities? Zero-based budgeting forces reevaluation of all assumptions.
Associating fixed costs with reliable revenue
Fixed vs. variable costs
- Fixed costs are not ordinarily affected by the number of projects, programs, plays, workshops, or classes given or clients served. Examples of fixed costs: permanent fulltime staff, office rent, principal & interest payments on a long-term loan.
- Variable costs are usually project-oriented and are more controllable or adjustable. Examples: number of characters in a play, number of participants served by a program, number of weeks a program runs, number of exhibitions or concerts, local or international, additional space rental requirements, etc.
- Semi-variable costs are in between - these must happen but can be mitigated somewhat. Examples: choosing color vs. black & white for a print job, bulk ordering of necessary items, short-term rental vs. purchase of equipment, engaging part-time temporary help rather than hiring fulltime permanent staff, etc.
Reliable vs. transient revenue
- Reliable revenue can be counted upon from year-to-year. Examples: Interest from highly liquid short-term investments such as Certificates of Deposit, dependable annual foundation gifts or government grants for general operating, long-standing contracts with government agencies or other entities, board contributions. During a recession, many revenue sources that have traditionally been dependable could become less so, moving from reliable more toward transient.
- Earnings from endowments usually considered reliable can be particularly hard hit during a recession. Building and maintaining permanently restricted endowments (as opposed to accessible operating reserves and special purpose funds) is not recommended for small and midsized organizations.
- Transient revenue fluctuates with program offerings. Examples: Admissions revenue, participation fees, project-oriented grants.
If reliable revenue is sufficient to cover fixed costs, an organization then knows it can adjust its variable costs to match its success in reaching its transient revenue goals.
Direct vs. indirect costs or overhead
- Direct costs relate to a specific project or program. Examples: scenery for Play #2, contracted faculty for the April-May workshops, supplies for the summer camp program, counselors for shelter clients.
Indirect Costs or Overhead
- Indirect costs (sometimes called Overhead or Common Cost Pool) do not relate solely and specifically to a particular project or program, but are necessary to its completion. Examples: office rent, telephone, Internet, copier usage, or management staff time devoted to the project.
- A formal indirect cost rate can be calculated and negotiated for some grant proposal budgets when allowed by the funder.
Overhead is a vital budget component for all projects, whether specifically funded or not, and should certainly be taken into account along with direct costs as funding request budgets are composed.
Non-cash Budget Items
Depreciation is a way to spread the expense of a large capital purchase over the number of years it will be in use, and this expense should be included in your budget. Your organization's board should approve a Capital Purchases and Capitalization Threshold Policy [See Example Capital Purchases and Capitalization Threshold Policy in Tools & Tips] that covers how it budgets for and approves capital purchases (i.e., equipment or furniture with a useful life of more than one year) and establishes a cost above which a purchase should be capitalized as a fixed asset rather than expensed outright. For example, a board may set the threshold amount at $1000, meaning that individual purchases of small tools, equipment, or furniture that cost less than $1000 are fully expensed in the current fiscal year when purchased. When a purchase exceeds the established cost threshold, and will be in useful service for more than one year, the item should be capitalized - that is, recorded as a fixed asset rather than an expense. The item will then be "depreciated" over the number of years determined as its useful life.
- Create or update a depreciation schedule (or fixed asset schedule) that calculates the amount of depreciation that needs to be included in the operating budget going forward. See Sample Depreciation Schedule in Tools & Tops section of this website.
- Consistently including depreciation in a balanced operating budget will provide the cash needed to replenish depleted assets by bringing in cash income to cover a non-cash expense. Not adequately budgeting for depreciation could eventually have the effect of eroding the organization's net assets.
Your organization may be fortunate enough to attract in-kind contributions comprising donations of professional services or other goods and services. It is wise to budget for and report these contributions, when they can be adequately documented, since it gives a truer picture of what it takes to do what your organization does.
- In-kind contributions are net-zero. That is, the contribution and the expense are equal, so they do not affect the bottom line net income, but they do increase the magnitude of the income and expenses. When budgeting for in-kind contributions, it is extremely important to ensure that the in-kind expenses are budgeted as well as the income. It would not be a good thing to balance a budget with non-cash income covering cash expenses.
- Documentation for in-kind contributions can be in the form of a letter from the donor or a bill from a vendor showing the full or discounted amount of the donated goods or services provided, etc.
- Volunteer hours do not qualify to be reported as revenue under GAAP (Generally Accepted Accounting Principles). Alternatively, a narrative note in your organization's audit can describe the role of volunteers and the impact of their hours, and perhaps estimate the number of hours even though a dollar value has not been recorded or reported.
- The value of the donation is reported to the IRS by the donor. Thank you letters from the receiving organization should only describe the service or goods and should not mention a dollar value.
- The organization should not record an in-kind donation unless it would otherwise have had to, or be willing to, pay for it in cash. In the case of donated professional services, the donor must possess the specialized professional skills being donated in addition to the previous requirement. See IRS Publication 1771 "Charitable Contributions-Substantiation and Disclosure Requirements" for further information.
Approved Budget vs. Year-end Forecast
A budget is a forecast or financial plan made at a point in time with the best information at hand. As an organization progresses further into the budget year, it only makes sense that better information will become available that would change the previously expected outcome in one or more line items. However, unless there has been a truly major change in the organization's structure or programs, it is generally not a good practice to change a budget once a budget has been approved by the board. It is better to create a column on financial reports that shows a Year-End Forecast, or Year-End Projection, based on the new information, and to explain any significant variances from the original budget. See the Statement of Activities page of the Internal Reporting section of this website for further details on report formatting. The Year-End Forecast/Projection is usually a better reference than the original in building the following year's budget.
Accrual vs. Cash
Accrual accounting - and budgeting - matches income and related expenses in the same fiscal period, regardless of the timing of the receipt or disbursement of actual cash. Many small and midsize nonprofit organizations operate on a modified accrual basis - that is, mostly on a cash basis except for year-end adjustments for accrual. See Basic Accrual Concepts for a discussion of six basic accrual concepts and how they affect the budgeting process.
Linking Mission and Money by Clara Miller
Financial Planning for Nonprofit Organizations by Jody Blazek, John Wiley & Sons, Inc., 2000
Learning from the Community: Effective Financial Management Practices in the Arts, a National Arts Strategies publication: Jim Rosenberg, Principal Author; Russell Willis Taylor, Editor
© 2009 Elizabeth Hamilton Foley