March 26, 2009

The Strategic Value of a Shared Understanding of Costs

Knowing the true cost of programs or services provides insight into an organization's effectiveness and efficiency. Cost data also can provide answers about whether too little is being charged for fee-based products or services. Originally published in 2003, Costs Are Cool by Susan J. Colby and Abigail Rubin provides valuable lessons in the importance understanding costs and their implications, and is no less valuable today given the current economic crisis. This condensed version appeared in the Nonprofit Director published by the Alliance for Children and Families, and reinforces the importance of economic clarity during good times of financial health and bad.

By: Susan J. Colby , Abigail Rubin

(This article originally appeared in the Nonprofit Director published by the Alliance for Children and Families, Issue 1, 2009. You may download a copy of the PDF from the Alliance's website.)

It need not be expounded upon: the funding situation is dire. Without much recourse, nonprofit boards and senior leaders are making extremely difficult decisions about whether to cut staff or scale back programs, and how to survive.

Competing priorities, coupled with unstable funding streams, make for challenging decisions about how to distribute limited resources. A report from the Bridgespan Group argues that making these decisions in a rational manner demands an understanding of the true costs behind any given program, service, or branch location.

"Costs are Cool: The Strategic Value of Economic Clarity" by Susan J. Colby and Abigail Rubin examines why resource-allocation decisions present one of the most powerful levers nonprofit organizations can apply in order to achieve the agency’s goals. And yet, while information about revenue—donations, grants, and earned income—is usually solid, knowledge about costs tends to be weak.

Knowing the true cost of any given program or service, however, provides insight into effectiveness and efficiency. Cost data can also provide revenue solutions, providing answers about whether too little is being charged for fee-based products or services.

Published in 2003, the report’s content proves no less valuable today, particularly given the current economic crisis. The report’s principles extend to times of good financial health as well, providing a tool for asking questions such as, “Should we open another site?” and “Should we expand a particular program?”

The following is a condensed version of the full Bridgespan publication. For most nonprofit organizations, the art of making tradeoffs is a condition of survival as well as a key element of success.

For most nonprofit organizations, the art of making tradeoffs is a condition of survival as well as a key element of success. The consequences of these tradeoffs are visible daily: in the activities a nonprofit offers, the programs it supports, and the initiatives it pursues. Accordingly, it is worrisome that the financial system in many nonprofits isn’t designed to support either short-term or long-term strategic decision making. Specifically, most financial systems don’t contribute to organizational knowledge about the true, all-in costs of providing services, running programs, and otherwise operating the organization.

Lacking this information, nonprofit executives often end up having to make important resource-related decisions on the basis of intuition, the skills and knowledge of the program staff, or the preferences of the organization’s funders. As a result, they run the risk of undermining their organization’s mission by failing to allocate resources to the programs and services that have the greatest impact.

True Costs Inform Individual Resource-Allocation Decisions

To make resource-related decisions in a way that maximizes an organization’s impact and promotes its mission, nonprofit leaders need to have a clear picture of the costs of operating their programs and services. The economic clarity that full cost data creates can provide invaluable input to decisions about how to allocate resources among programs and across them, whether to expand into a new location, and where to set the level of funding required to sustain the organization’s operations.

Which programs to fund? The most basic resource-allocation decisions relate to funding multiple programs in a single department. For example, one of Bridgespan’s clients provides a variety of counseling, adult education, youth, and economic development services. An analysis of its costs showed that within the economic development department, the employment-services program and the resume-services program were incurring the same expense; it was costing the same amount of money to place a client in a job as it was to help her prepare a resume.

Because having a job provides clients with greater economic selfsufficiency than simply having a resume on hand, the organization decided to focus its resources on the employment-services program instead of growing the resume-services program as it had originally planned.

Full and accurate cost data can be equally illuminating when an organization’s leaders are wrestling with the best way to divide resources among multiple sites. This was the situation confronting a nationwide educational organization with seven regional affiliates.

Because the organization’s existing accounting system reported all its financial information on a line-item basis, regional cost data had never been collected.

When this data was gathered and analyzed, the organization learned that the cost of training teachers varied greatly by locality. These findings prompted a re-evaluation of the regional offices, which led to both the allocation of additional resources to efficient regions and the initiation of efforts to help the other offices learn from their peers and become more cost-effective.

Should we expand to a new location? Opening a new site brings the potential advantage of increased efficiency, because some of the organization’s costs (such as fundraising, marketing, and human resources) can be shared between locations, lowering the cost for each by creating economies of scale.

On the other hand, many costs cannot be shared: the unique start-up costs required to establish a program in a new region, for instance, as well as site-specific costs such as rent, direct labor, and materials. Understanding the mix of costs that will recur at the new location and costs that can remain at the original site (and thus be leveraged by the new operation) is essential in evaluating the full cost of replication.

Such understanding was invaluable for the leaders of one West Coast organization that runs a successful workforce-development program. Many voices urged the organization to expand, including one funder that was particularly enthusiastic about seeing the training program established in a new geographic region.

After careful assessment, however, the staff decided against the expansion. The decision was informed in part by an examination of the organization’s cost structure, which showed that overhead costs constituted a significant portion of its total operating costs. As long as these costs were divided among several existing programs, the organization could absorb them without compromising its viability. But if one program had to carry them alone, as the training program would have to do if it were replicated in the new location, the burden was unlikely to be sustainable.

Coupled with an understanding of the risk of starting a long-term program with guaranteed short-term funding and a determination that the economic climate wasn’t right for expansion, this analysis convinced the organization that replication would not be a prudent decision.

How much should we charge for products or services? In addition to contributed revenue, a growing number of organizations also provide products or services that serve as sources of earned revenue. Given nonprofits’ natural inclination to charge as little as possible for these products and services, the prices are often set at levels that fail to cover the actual costs.

This was the case for a nonprofit that offers affordable classes on technology-related subjects. The organization charges fees for the classes, and its management had always believed them to be a source of earned, not just additional revenue.

However, a close examination of the organization’s cost structure showed that the classes were actually a net drain on resources. Accurate cost data (along with market data and program knowledge) allowed the staff to ask—and answer—concrete questions about class size, cancellation policies, and the types of classes to offer.

Costs From a Strategic Perspective

Striking as the effects of understanding true costs are on individual decisions, the impact on an organization’s strategy can be even more powerful. Accurate cost data also makes it possible to look at program finances from a strategic perspective, to assess the flow of funds within the organization as a whole.

With a full understanding of all their programs’ costs, decision makers acquire a clear view of how, precisely, the organization’s scarce resources are being allocated. They can identify which programs are covering their own costs or even generating surplus funds, and which ones require subsidies. As a result, they can determine whether scarce resources are being used in the ways that most effectively advance the organization’s mission.

The calculations themselves are relatively straightforward. Since nonprofits generally have fairly accurate data for their programs’ earned and contributed revenues, once they have a comparably strong understanding of their full program costs, they can match program revenues to costs in order to determine each program’s net contribution.

This approach makes the economics of the organization transparent; it also represents a considerable departure from the way in which nonprofits historically have considered their program finances.

Many nonprofit executives still think about the revenue side of their organization separately from the cost side; and as long as total revenues are sufficient to cover total expenses, they tend not to calculate whether individual programs are “earning” or “losing” money.

This approach is all the more attractive for the many nonprofits in which costs historically have been bundled into financial categories that basically tell you nothing about what the costs actually do. Capturing and allocating full cost data properly is difficult enough when it’s done from the start. Recasting historical data (which often consists of people’s time) is truly hard to do.The value of these calculations lies entirely in their ability to highlight situations in which program economics are out of line with missiondriven priorities. Cognizant of which programs contribute positively to the organization and which represent a net drain on its resources, decision makers can examine the flow of funds within their portfolio of services to make sure that their allocations are supporting—and not undermining—the organization’s desired impact and focus.

But nonprofits have varying motivations for the activities they undertake. While many programs may be intended to both further the mission and contribute to financial sustainability, in practice each will favor one more than the other. Recognizing and being explicit about which programs serve which purpose allows organizations to ensure that their activities strike the balance they desire. A matrix that incorporates both mission alignment and financial contribution makes this framework concrete.

Making Full Cost Data Routine

Nonprofit financial and reporting systems, the culture of many nonprofit organizations, and the funding environment in which nonprofits operate all work to obscure true cost information or make it unnecessarily difficult to obtain.

As an initial obstacle, most nonprofits have only rudimentary financial systems, and the standard accounting packages on which they tend to rely are seldom conducive to tracking and understanding the true costs of operation. Introducing more fully developed financial and accounting systems into nonprofits is an obvious first step to strategic cost management.

The culture of nonprofits also works against economic clarity. For many nonprofits, focusing more than a modest amount of money and attention on understanding such traditionally commercial matters as costs represents a diversion of valuable resources from activities that further the organization’s mission.

Additionally, even though staff labor costs (people’s time) represent many nonprofits’ single biggest cost, the culture in most of these organizations isn’t conducive to tracking how employees spend their time, so that those costs can be allocated to the relevant activities and programs. Unlike law or consulting, where employees are accustomed to documenting their time in order to assign it to clients, nonprofit employees are not only unlikely to be familiar with such recording systems but also may resist any efforts to quantify the cost of their activities.

Lastly, the capital market in which nonprofits operate pushes against economic clarity in a variety of ways. Many funders prefer to support programs and projects rather than overhead expenses such as fundraising and administrative costs. They also tend to prefer providing seed money to support new programs rather than sustaining existing ones.

Looking Ahead

Competitive forces of many kinds shape the world that nonprofits inhabit. Within the sector itself, more organizations are competing for scarce resources such as funding and staff. Nonprofit start-ups appear with startling regularity. For-profit businesses continue to enter the marketplace in growing numbers in industries such as health care and education.

To participate successfully in this new environment, nonprofits must be able to articulate coherent, well-structured strategies that will allow them to deliver on their chosen mission. Economic clarity is an invaluable—and essential—input to this work. For today’s nonprofits, accurate cost information may prove to be priceless.


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