Wednesday, May 5, 2010

Fixed Costs and the Not-for-Profit

Most not-for-profit organizations (not to be confused with not profitable organizations) rely on three sources of funding: endowment income, corporate contributions and individual contributions.

To focus on the fixed costs aspect of this topic, let’s say the organization is a church with no endowment. It won’t receive corporate contributions, and so it must rely on individual contributions (and a few fund raisers) for its income.

And just for fun, let’s say a generous member decides to make a one-time gift of $20,000.

What could the church do with such a gift?

They could start an endowment fund, not touch the principal and use the income from the fund each year. They could pay off a chunk of the mortgage on the church building, or remodel the church kitchen. The uses are endless, but I’ll bet large amounts of money that among the alternatives, a great groundswell will arise for using the money to pay staff. The proposal might take the form of increasing staff wages or benefits; it might instead focus on increasing hours worked.

Staff salaries aren’t exactly fixed costs. Salaries and benefits can be reduced. Staff positions can be eliminated or have their hours cut back. Salaries in particular are referred to by economists as “sticky downward.” That is to say, there exists a great reluctance to reduce nominal salaries. When times are good salaries go up, but when times are bad they do not go down as quickly. Given bad enough and long enough times, salaries will decline.

Back to our $20,000 largess. Let’s say we’re in a more reasonable interest rate environment than today and can expect to safely earn 5% on our money. The $20,000 will spin off $1,000 a year. The church could afford to increase salary and benefits by $1,000 bucks because that’s the income the $20,000 will generate each year. Income and Expenses would increase by the same amount.

Big whoop. This won’t satisfy anyone.

However, applying any greater amount of the one-time largess to the sticky downward costs of employee compensation means the church is eating into the $20,000, and at some point the well will run dry. When it does, the church needs to find a new source of funding or enter a painful (and often hurtful) process of cutting compensation and/or hours.

In a church that is growing and needs additional staffing to help it grow, it could be reasonable to spread the $20,000 out over (say) four years. This method implicitly challenges those who are getting the additional compensation to add enough value to the church that at the end of the four years congregants will in the course of normal business be kicking in an extra $5,000 to keep the higher staffing levels. However, if that is the case, it is important to not take increased contributions as they come in and apply them to something else.

If they do apply increases in contributions in years 1-3 to something else, they’ll find themselves in the same position I did in 1984 with my fixed costs rising substantially through a number of individually reasonable decisions. [See: earlier post ] In the church example, at the end of four years the $20,000 is gone, and for the next year they need to replace $5,000 of income.

This scenario crops up a lot in churches under various guises. Sometime it is a one-time unrestricted contribution as in the scenario just discussed. Sometimes it’s a surplus from a previous year. Sometimes it is money pledged to match increased contributions.

The last case is a bit trickier. The assumption is that when parishioners increase their pledges because of a special match, they will maintain the new, higher level of giving in the future. For many people that is the case (contributions are somewhat sticky downward) and so applying those higher pledges to increased fixed costs can be (mostly) justified.

However, the generous match is a one-time offer and churches should treat it as such—at least that’s my opinion. What’s yours?

P.S. Happy birthday to my dog, who turns 10 today.

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