The Full Cost Mindset Why Every Executive Director Should Adopt It
Working in the nonprofit sector is not easy—I know that. You know that. And yet we continue doing what we do because of our why: the people we serve. However, we can’t ignore the practicalities (and by that, I mean the need for consistent revenue). So today, I want to share something very important: the full cost mindset.
This post is inspired by this webinar conducted by Nonprofit Finance Fund (NFF). After viewing the webinar, I was blown away and thought, “My nonprofit leaders need this!”
So here I am…excited to break down the full cost mindset with you. 😃
Understanding the full cost mindset is paramount for sustainable growth and truly impactful outcomes. In this article, I delve into the significance, advantages, and practical applications of the full cost framework, particularly in the nonprofit sector, shedding light on the challenges nonprofits face in achieving financial stability and the importance of generating surpluses.
Now, nonprofits—you—often operate in a unique landscape where you provide services to individuals who cannot afford to pay the full cost or even pay at all. As a result, you rely on subsidies from third-party payers and funders—or, cover the costs yourselves, leading to a dual focus on mission work and financial management. You experience firsthand the difficulties of achieving financial health in this complex environment.
Recognizing the inherent challenges nonprofits face, it is clear that breaking even is impossible. You simply can’t afford to live hand-to-mouth knowing that people are relying on you and that without funds, they won’t have access to the service you provide.
Repeat after me: Nonprofits require profits and surpluses to thrive and operationalize your mission effectively.
By embracing the full cost mindset and acknowledging the importance of generating surpluses, you can steer your organization toward long-term sustainability. (Which, as you may already know, is what I help my nonprofits achieve!)💪🏾
Let’s start with the different types of needs nonprofits face.
It is the role of the Executive Director to manage the intricacies of financial planning, budgeting, and resource allocation to achieve financial stability and fulfill your organization’s overarching goals. In addition to day-to-day expenses, there are other types of needs.
Liquidity refers to the availability of cash on hand to meet day-to-day financial obligations and keep operations running smoothly. The Executive Director has to ensure there is enough cash to cover expenses, even when there are mismatches between incoming and outgoing funds. This requires careful cash management, forecasting, and cash flow accounting to anticipate and address any potential shortfalls. Having sufficient liquidity provides stability and enables you to navigate financial challenges with confidence.
Adaptability and responsiveness to changing community needs and external factors are crucial traits for your nonprofit to have. Having flexible resources allows your organization to grow, make adjustments, and seize opportunities as they arise. Whether it's scaling up programs, exploring new initiatives, or responding to emerging challenges, adaptability ensures that you can effectively meet evolving demands.
Durability encompasses the resources necessary for long-term sustainability and future-proofing the organization. This includes building:
Infrastructure
Investment reserves
Other assets that contribute to your organization's stability and ability to fulfill its mission over time.
It’s important to note that these needs vary depending on the nature of the nonprofit.
As an example, for a nonprofit organization focused on land conservation and ecosystem preservation, durability becomes a crucial factor. Land trust organizations, for instance, need to acquire and maintain protected areas, such as forests, wetlands, or wildlife habitats. These lands serve as critical resources for long-term conservation efforts. The durability of these protected areas ensures the preservation of biodiversity, supports ecosystem functions, and provides opportunities for research and education.
In contrast, nonprofit organizations that focus on advocacy for environmental policies or engage in disaster response and relief work may prioritize adaptability. These organizations often need to respond quickly to emerging environmental challenges or crises. They may require the flexibility to allocate resources and pivot their efforts to address urgent issues, such as climate change impacts, natural disasters, or policy advocacy campaigns.
In our sector, discussions about costs often revolve around terms like program versus overhead or direct costs versus indirect costs. These distinctions are used to delineate the financial aspects of nonprofit operations. However, the concept of full cost goes beyond these categorizations and reflects the full scope of your organization’s needs.
Full cost, sometimes referred to as real cost or true cost, asks you to consider all the financial resources required to run an effective organization in the long term. It challenges you to move beyond the limited focus of covering direct or overhead costs. Instead, it aims to build up your nonprofit to not only meet immediate financial obligations but also respond, adapt, and thrive in the face of changing community needs or unexpected challenges.
By embracing the full cost mindset, you learn to:
1. Elevate your thinking beyond the “false dichotomy” of program versus overhead costs
2. Acknowledge the importance of both short-term and long-term needs
3. Recognize that financial sustainability requires a holistic understanding of your nonprofit’s operating context
Moreover, full cost is a powerful tool for advancing racial equity within the nonprofit sector. It encourages funders to consider the historical context in which organizations and communities operate. It recognizes the practices of wealth suppression in indigenous, Black, and other communities of color, often through systemic and discriminatory practices not witnessed in white communities. By incorporating this context into the conversation about costs, full cost enables a nuanced understanding of resource allocation and fosters equitable funding practices.
Context is everything! ✨
The full cost framework has six key components. These provide a comprehensive approach to building out an effective accounting system, financial planning, and resource allocation, ensuring your nonprofit can adequately address its financial needs for long-term sustainability. Let’s explore each component in detail.
These refer to the comprehensive expenses necessary for running an effective nonprofit organization. It encompasses all the expenses and investments required to fulfill the organization's mission and maintain its operations over the long term. Basically, these are all the things that shows up in your income statement (also known as a profit-loss statement).
Total costs include:
Operating (regular and recurring; e.g,, salary, rent) and non-operating (irregular, one-time, unexpected: e.g., roof, A/C)
Direct (program) and indirect (overhead)
Consulting and Contractors
Depreciation
Unfunded
However, these don’t include:
Purchases that are capitalized (e.g., property and expensive equipment)
Repaying debt principal
*An important note on unfunded expenses: These are expenses that, if covered, would allow nonprofit organizations to operate at their current level in a manner that is reasonable and fair. Sweat equity, where individuals are overworked and underpaid, is a common unfunded expense.
A good example of sweat equity is when dedicated volunteers or staff members go above and beyond their designated roles and put in extra hours of work without receiving appropriate compensation. This often occurs when individuals are passionate about the organization's mission and are willing to contribute their time and effort beyond what is expected.
Say you’re a nonprofit that focuses on providing after-school tutoring programs for underserved communities. The executive director (you?) frequently works well beyond the standard 40-hour workweek. You may take on additional responsibilities, such as managing program logistics, recruiting volunteers, and handling administrative tasks—all without receiving compensation for the extra effort put in.
This sweat equity represents an unfunded expense for the nonprofit. If you were to account for and adequately compensate the executive director for their extra hours worked, it would create a fairer and more sustainable work arrangement. By acknowledging and addressing this unfunded expense, you can foster a healthier work-life balance for staff members and ensure that their valuable contributions are properly recognized and rewarded.
Working capital refers to the funds set aside to address the expected ups and downs in cash flow, enabling smooth business operations even when cash inflows and outflows do not align seamlessly.
The purpose of working capital is to provide a safety net, ensuring that organizations can sustain their activities in situations where money may arrive late, or immediate bills need to be paid. It represents accessible funds held in a checking account that can be utilized by management as needed. Unlike restricted funds, working capital is not designated for specific purposes, granting flexibility in how it is used.
How much working capital is needed depends on your nonprofit and its unique cash flow dynamics. For some nonprofits, having one month's worth of working capital may suffice if its cash inflows and outflows align well on a monthly basis. However, if your organization relies on government funding or experiences extended delays in cash flow, you may need to maintain reserves equivalent to six or even 12 months of expenses. Without access to an adequate working capital buffer during these periods, you may struggle to operate at optimal levels throughout the year.
Effectively managing working capital requires finding a balance between maintaining sufficient reserves to navigate cash flow challenges and deploying funds efficiently to support the organization's mission. By analyzing your cash flow patterns and determining the appropriate level of working capital, you can mitigate financial risks, enhance operational resilience, and ensure the continuous delivery of your programs and services.
*NOTE: Working capital does not include dollars to cover lost revenue or deficits. 📉
This is the goal: Nonprofits ought to have reserves, dollars set aside for the unforeseen in case the need arises. Reserves:
Are eventually replenished
Are accessible to management under certain conditions
Usually require approval from the board
They can come in the form of cash (in the bank) or investments that can be liquidated quickly.
There are four general designations of reserves.
Operating reserve: protects from risk by covering short-term deficits
Fixed asset reserve: for maintaining building & equipment; to pay for repairs or replacement
R&D reserve: allows for trial & error (e.g., artistic reserve, investigate new program approach)
Investment reserve: for generating revenue
Reserve designations vary, and not every type of reserve is necessary for every organization. However, the importance of reserves, in general, cannot be undermined. The purpose and size of reserves differ based on the organization's specific needs. A fixed asset reserve would make sense for a nonprofit without property or equipment. Therefore, the decision to maintain reserves depends on individual circumstances.
Reserves should be available to management when specific conditions arise, typically with board approval, indicating the appropriate time to utilize these reserves. By tailoring reserves to organizational requirements, they serve as a financial safety net and a strategic resource when needed.
When you borrow money, you have to pay it back.
Common sense, right?
So why does debt principal repayment warrant its own slice of the pie in the full cost framework?
One: Common sense is not so common. 🤷🏽♀️
Two: Paying back the principal balance on a loan is an item on your balance sheet.
So, if you take on debt to finance various activities, such as facility expansion, program development, or operational needs, you have to repay the principal. This means you have to allocate funds from your organization's revenue or surplus to gradually reduce the outstanding debt over time.
By making regular principal payments, you can work towards reducing your overall debt burden and improving your financial stability and long-term sustainability.
When your nonprofit organization purchases new equipment, buys furniture, leases land, or makes leaseholder improvements, these are considered fixed asset additions. Fixed assets are long-term assets that are not meant for immediate consumption and have a useful life of more than one year. Unlike simple maintenance or replacement of existing assets, these additions represent significant investments in the organization's infrastructure or operations.
It's important to note that this is not meant for small equipment purchases that are not capitalized or recorded on the balance sheet. Such purchases are typically expensed immediately rather than considered long-term assets.
Change capital is funding that allows your organization to reinvest periodically to transform your business model. This involves making substantial changes to your mission, scale, or approach to generating and allocating financial resources. Unlike organic growth, which entails gradual expansion over time, change capital involves accessing significant, flexible, and often multi-year funding from external sources.
Change capital serves as a catalyst for transformative initiatives that go beyond your organization’s existing capacity or scope. It enables you to explore new strategies, expand your reach, or implement innovative approaches to achieve your mission.
How do you calculate change capital?
Calculating change capital involves considering various factors and making projections based on your surplus-generating business model, revenue-generating activities, and the timeline to secure new revenue and funding sources. Here’s a breakdown of the components involved:
Create detailed projections for a surplus-generating business model: The first step is to create detailed projections for your surplus or net income. This involves estimating the revenue streams and deducting the associated expenses to determine the surplus generated. It’s important to consider both the short-term and long-term projections to assess the financial viability of the business model.
Identify planning/upfront/startup costs: When implementing revenue-generating activities or launching new initiatives, upfront costs are often involved. These costs may include market research, product development, marketing expenses, hiring new staff, acquiring the necessary equipment, or securing licenses and permits. Calculating change capital requires estimating these planning or startup costs to ensure adequate funding is available.
Layout the timeline to secure new revenue and sources: Change capital calculations should consider the timeline required to secure new revenue streams or funding sources. This involves assessing the time it takes to establish partnerships, secure grants or donations, or generate revenue from new initiatives. Understanding the timeline helps identify the amount of capital needed during the interim period until the new revenue sources become operational.
Two types of revenue an organization needs to balance during a change capital infusion
During a change capital infusion, two types of revenue need to be balanced: “buy dollars” and “build dollars.”
Buy dollars: “Buy dollars” refers to the funds needed to purchase or acquire external resources, assets, or services required for the organization’s transformation. This could involve buying equipment, technology, or reinforcing infrastructure.
Build dollars: “Build dollars” refers to the funds needed to invest in internal capacity-building and development. This involves allocating resources to enhance your nonprofit’s capabilities, such as staff training, research and development, process improvement, marketing and branding, or expanding operational capacity. The emphasis is on building internal strength and capabilities to support your growth and transformation.
Balancing these two types of dollars is crucial for effective change capital management. While “buy dollars” provide the external resources required for the transformation, “build dollars” ensure that your nonprofit has the necessary internal capacity to utilize those resources and drive sustainable growth effectively.
The distinction between "buy dollars" and "build dollars" is important for nonprofits and funders to understand. It helps clarify the type of funding needed and the rights associated with it. In the nonprofit sector, financial statements often don't differentiate between these two types of dollars, which can lead to confusion and unrealistic expectations.
When you know what kind of money you need, and the funder understands the rights attached to that money, it sets your partnership up for greater success.
Funders who are buyers, meaning they are paying for existing services, are entitled to budgets and standard reports for the years they are funding. They shouldn't ask for new reports that require additional resources the funder isn't providing.
On the other hand, funders who are builders, funding new or transformative initiatives, have different rights. They can ask for multi-year budgets, projections, strategic plans, and discussions about expanding the organization's activities. However, it's important that a buyer doesn't claim builder rights they are not entitled to.
Clear communication and agreement on funding expectations between nonprofits and funders help establish a healthy and successful partnership.
The full cost framework is about advocating for these six slices of full costs to be recognized and considered. It's about moving away from thinking only about immediate financial needs. Even if you start including unfunded expenses and facility costs in your budget, it's a positive step.
Prioritize total expenses, working capital, and reserves. Some organizations may need debt repayment, fixed asset additions, and change capital—but not all the time.
Your full cost accounting needs will vary depending on your situation and can change over time. You are not expected to meet all your full cost needs immediately. Financial strength is often built gradually, but funders can help accelerate the process by providing large and flexible grants, especially to organizations in under-resourced communities.
To transform the conversation between nonprofits and funders, it's important for you to be open to questions, have a strong organizational strategy, and communicate clearly. Overall, it's a collaborative effort that requires careful analysis, and both nonprofits and funders play important roles in advancing the understanding and implementation of full costs.
I know that this is a long read, but my hope is that by understanding this framework, you will be able to shift from running your organization hand-to-mouth (I have to say it: a nonprofit is a business!) to a mindset of generating profits, having reserves, and achieving sustainability. Own your financial story!
If you have some time, I highly recommend watching the NFF webinar here.