If business is part mystery and part art, it’s also basic science and arithmetic. Fairly ordinary rules predict financial results. And, they seem to be universal and difficult to ignore.
But the nonprofit sector is a different and irrational world, like stepping through a looking glass. The rules, when they apply at all, are reversed, and the science turns topsy-turvy. Not only are the rules that govern money and business dynamics different from those in the for-profit sector, they’re often unknown, even among nonprofits and their funders.
Nonprofit managers sometimes find it difficult to explain their unique universe to board members and the public, partly because the rules sound so improbable.
This true/false quiz is based on seven core assumptions that are pretty dependable in the for-profit sector, but with nonprofits, a challenging pattern develops.
Rule #1: The consumer buys the product. True or false?
In the nonprofit sector, this is usually “false.” A primary job for many nonprofits is to provide vital services to people who can’t pay for them, or at least can’t pay the full freight. A third party usually pays for the product on behalf of the consumer.
Nonprofit social service, healthcare, job training, housing, and similar businesses provide services to one consumer but often are paid by another—or, frequently, by a dizzying array of others.
Many nonprofits therefore must “sell” their wares both to the users and to the people who pay. The players in these two markets have diverse and sometimes contradictory goals, and nonprofit managers spend time and attention marketing to them all.
This adds complexity and high transaction costs to the business—and a constant tension over mission.
Rule #2: Price covers cost and eventually produces profits, or the business folds. True or false?
This is false, and one of the harshest business realities of the sector. In the nonprofit world, you do lose a buck on virtually every widget, and no, you don’t make it up in volume either. The difference is, you keep doing it!
In the for-profit universe, a manager operating an unprofitable business will eventually fold, but most nonprofits’ missions dictate that they accept a “market defect” of some kind—lack of profit being the most common—as a standard operating condition.
Why don’t they exit an unprofitable business? Because their nonprofit missions dictate that they stay in it, providing shelter, disaster relief, and similar services to people with no means to pay and no other options. Adding to the lack of profitability, most nonprofit work is skilled and labor-intensive (human services, education, surgery).
For some, other fixed costs are also high. But, raising prices is difficult if not impossible for elderly, low-income, or uninsured consumers. This creates a double whammy for management: lack of working capital to fund growth and a continuing need for larger subsidies as growth proceeds.
To handle this, nonprofits usually run two businesses: the core, mission-oriented business and a second “subsidy” business. Subsidy businesses include fund-raising, special events, bingo, capital campaigns, for-profit related and unrelated businesses (bookstores and gift shops), endowment management, and many creative fundraising ideas. The subsidy business needs staffing and investment all its own and is subject to its own laws of growth.
Rule #3: Cash is liquid. True or false?
For most nonprofits’ revenue, the answer is false because it’s restricted cash! Many sources restrict their funds to specific purposes—e.g., teachers’ salaries or books. By nonprofit accounting rules, the restricted cash must then sit in the bank until you use it for this purpose.
Let’s say your donor restricts a cash gift to replacing mattresses for your homeless shelter. If there’s a plumbing crisis, you can’t touch that cash. Even with cash in the bank, you’re going to need another source of payment, fast. This creates the impression that a nonprofit is solvent—even flush—when it’s actually in a cash crisis.
Rule #4: Price is determined by producers’ supply and consumers’ ability and willingness to pay. True or false?
The triangular aspect of the nonprofit customer relationship makes this answer false. Supply and demand are usually plotted on a two-dimensional graph. But the nonprofit relationship is not so simple. It’s more than a battle for market share from consumers making relatively simple buy or no buy decisions about a commodity sold by competing suppliers. It’s a complex market in which the battle is often for both subsidy and fees.
One variation on Rules #3 and #4 is when the payer (government, for example) can’t or won’t cover the entire cost of the services. The nonprofit is left with the difficult task of finding additional subsidy, turning money away, or providing undercapitalized services to clients, with eventual decline in quality.
Rule #5: Any profits will drop to the bottom line and are then available for enlarging or improving the business. True or false?
False. To most business people, this might seem like the last straw. Even if a nonprofit finds a way to become more profitable, save money, or build working capital for the future, it is often restricted and thus not available to use. And to top it off, many in the sector have the attitude that surpluses are bad and signify that you don’t really need more money.
Rule #6: Investment in infrastructure during growth is necessary for efficiency and profitability. True or False?
False. The nonprofit rules of business largely prohibit investment needed to increase efficiency as growth occurs. Third parties paying for a service often prohibit or put limits on spending for anything but “direct programs,” not realizing that there are costs of growth in this highly regulated business. Donors may think that all other costs (which look like wasteful luxuries anyway) will disappear. Thus, funds to defray costs that all of us—nonprofit or for-profit—consider a regular, sensible cost of business and an investment in greater efficiency are frequently unavailable and considered “above and beyond” the real cost of providing services.
Rule #7: Overhead is a regular cost of doing business, and varies with business type and stage of development. True or false?
It’s unanimous! They all are false! For some reason, overhead is seen as proof that a nonprofit is not putting enough of its resources into programs.
Imagine you own a restaurant. A customer says before signing the credit card slip, “I’m going to restrict my payment to the chef’s salary. He’s great, and I just want to make sure I’m paying for the one thing that makes the real difference here. I don’t want any of this to go for light, or heat, or your accounting department, or other overhead. The chef is where you should be spending your money!”
The irony is that a technique meant to control costs actually undermines efficiency and program quality. Nonprofits’ inability to invest in more efficient management systems, training, and program development over time means that as promising programs grow, they will burden the organization financially.
The results are burned-out staff, under-maintained buildings, and other symptoms of inadequately funded “overhead.”
In light of these “facts of nonprofit business life,” it’s fairly easy to see why it’s difficult for the nonprofit sector to find and retain executive leadership, to become self-sufficient or sustainable, and to attain economies of scale while maintaining program quality. All the goodwill, brainpower, capacity-building, finger-wagging, standard-setting evaluation, and impact measures will eventually be undermined by the way we finance these enterprises.
The financial system we have put in place and support is the worst enemy, not only of the improvements everyone is trying to make, but of the socially critical programs and services this system is meant to sustain. More and more diverse scrutiny from government and other funders will create more transaction costs in an industry already carrying an overly high level. This will burden large and small nonprofits alike, giving small, innovative, and efficient organizations an infusion of costs as they grow.
Funders can go a long way toward lowering transaction costs for themselves and their grantees by modifying the way they do business. Funders of all types and at all levels—including individuals and government—need to be aware of the toll the financing system takes on nonprofits’ “human capital.”
For all supporters, unrestricted grants are the most positive financially and should be the rule and not the exception. Anything else generally creates cost for the recipient. Unrestricted funding does not mean that funders cannot or should not be actively involved in communicating with the recipient about plans for the funds, budget, and program strategy. 
