Mind the Gap: True Program Costs

Imagine this budget planning conversation at a human services nonprofit:

“The county wants to expand our contract! Isn’t that great?”

The easy answer is: Yes! We can provide more services in our community! But the smart answer is: It depends.  In this example, we’d need to ask ourselves a couple financial questions:

• Can we afford to expand the program?
• Do we know what it costs to deliver this service? What if the cost is more than the funding?

For the sake of this example, let’s say that the contract with the county pays $75 for each day of service provided, supported by an approved budget. Often, though, the true cost is some other amount altogether. It wouldn’t be a surprise if the real cost is $100, but for too many nonprofits the answer is, “we don’t really know.” That is a problem. The decision of whether or not to agree to an expanded contract has a financial impact, and we need good information before we decide.

According to the State of the Nonprofit Sector 2015 Survey, released a few weeks ago by Nonprofit Finance Fund, the gap between funding and true costs is one of four top financial challenges for nonprofits.  (We heard similar feedback at the Finance Conference back in March.) The summary report on the survey includes several topics of strategic advice for nonprofits, starting with this:

Are we asking for full funding?

58% of respondents reported that funders (government, foundations, or individuals) never or rarely cover the full cost of the projects they support. And a third of respondents that received government funding (either federal, state, or local) reported average indirect cost rates of 0–3%. Although nonprofits have made some progress, the problem still persists. Yet sometimes, we contribute to the problem. To stand out in a competitive fundraising environment and serve our clients in new and better ways, we often ask for—or accept—funds that don’t cover the full cost of programming. On top of this, nonprofits don’t always know their full costs. This chronic under-pricing can lead to staff turnover, service disruption, or bankruptcy. No one wins. We cannot turn down all grants that don’t pay full costs, but we can work harder to articulate to funders what our full costs are.

Absolutely.  This is one of the complications of nonprofit business models. What are the options for the hypothetical nonprofit above if the full cost of providing their program service is $100, but the county only pays $75?  At a basic level, there are three approaches: price, cost, or subsidy.  They can try to negotiate with the county for a contract that covers the full cost. They can reduce the actual costs with budget cuts so that they match the county funding. Or they can fill in the gap from a different source, such as fundraising. The only wrong answer is to ignore the question and pretend that everything will be fine.

Most nonprofits struggle with this question all the time, managing different programs with different financial models. Some programs may be financially self-sustaining, or even generate a surplus—but other activities require periodic or ongoing subsidy from fundraising or other program areas. Determining whether and how to support these services is an essential strategic decision for nonprofits. Knowing the real costs of each program allows us to make informed choices that will lead to mission and financial success.

This is why we developed a how-to resource to guide nonprofits through the steps of calculating and understanding the full cost of programs. The process includes decisions about how staff spend their time, what budget items are shared among several program areas, and how to allocate an appropriate amount of overhead to programs and administration. The guide, spreadsheet template, and a short video are all available in our Resource Library.