Levels of Reserves

Step 4 referred to cash reserves. What is the appropriate level of reserves to maintain? Most people understand the need for a cushion against an unexpected, or expected, downturn in the organization's financial situation, or for an unanticipated, or anticipated, opportunity to expand services. But there is little guidance available about how large such reserves should be. Although it would be nice to have enough in the bank to cover any possible problem or opportunity, this is rarely possible, nor is it necessarily desirable. Every dollar held back in reserve is a dollar that is not being used to provide program services to the organization's constituency. If no amounts were held back, more meals could be served to the homeless, more concerts given by the orchestra, more work done to find a cure for cancer—at least in the short run. But without reserves, the organization might not survive for the long run, and then there will eventually be no meals, concerts, or cancer research. Somewhere between is the happy medium, but where?

Reserve levels are necessarily a matter of judgment. The authors suggest the following factors for consideration in making that judgment for a particular organization:

• How predictable are the organization's revenues? How likely is it that there might be a sudden and significant shortfall that could hurt the organization's ability to continue its programs?
• How predictable are the organization's expenses? How likely is it that there might be a sudden and significant need to spend resources beyond those planned for in the budget? Such a need could result from either an unexpected increase in the cost of doing what has been planned (such as a wage increase won by a labor union, or an increase in the price of some commodity purchased), from the need to respond to a natural or man-made disaster such as a fire, flood, or earthquake, or from an unexpected opportunity to meet a new community need by expanding the organization's program activities into new areas.
• If one (or both) of the preceding two scenarios occurs, how certain are management and the board of their ability to tap new or increased sources of financial resources quickly? Are there existing donors who would readily respond to an emergency appeal for support? Are there other donors, such as a local foundation, a United Way, or a governmental unit, who would help? Could revenues from sales of goods or services (if such exist) be rapidly expanded? Would creditors be willing to postpone debt payments? Are there other assets that could be sold for cash on short notice? Are there lenders (either individual or commercial) who would make a loan to the organization? Does the organization already have an available line of credit with its bank? (If not, why not?)
• Could planned expenditures be reduced or deferred, at least for a while, without long-term harm to the organization's programs? Many not-for-profits are quite labor-intensive. Payroll expenses are often not easy to cut, and payroll taxes have to be paid to the government. Consideration should also be given to whether an expense results in an outlay of cash. For example, depreciation expense recorded in financial statements (and sometimes reflected in budgets) does not result in an outlay of cash in the year the depreciation expense is recorded. However, it is reasonable to expect that after its useful life, the asset being depreciated will need to be replaced. A cash expenditure in the year of replacement might leave a significant effect on a budgeted cash balance while the “expense” for this replacement, in the form of depreciation expense, will be recognized over the useful life of the asset.
• How risk-averse is the organization's management? How willing is it to “run close to the edge” and count on its ability to deal with problems or opportunities as they arise without having much in the way of ready reserves to draw on?

None of this has yet directly answered the question of reserve size. Unfortunately, there is no answer that works for all organizations all of the time. Each organization has to make its own determination based on its own circumstances. Some people use as a rule of thumb somewhere between three and six months' expenditure as a desirable reserve level. Consider all aspects of your particular situation before making this determination.

Once the decision as to desired size is made, the actual reserve can be handled in several different ways. One way is to do nothing beyond monitoring the level of unrestricted net assets for conformity with the established reserve level. Some organizations like to place an amount of cash or other liquid assets equal to the reserve amount in a separate bank or investment account. This may serve as a form of self-discipline by making it less easy to spend the reserve assets. A more formal procedure is to have the board vote to designate an amount of the unrestricted net assets as an operating reserve on the balance sheet, although the authors caution that such a procedure may be confusing to financial statement readers.

A final question that sometimes comes up is whether there is some upper level of reserves which, if exceeded, will attract unwelcome attention from the Internal Revenue Service. The answer is, almost always, “no.” The tax laws tell the IRS to be concerned with how an organization uses its resources to further its tax-exempt purpose, but do not mention any limits on how much the organization may accumulate. Some major universities and foundations have assets in the billions of dollars, without raising any concern. The point is that these organizations are using these assets, in many cases, to generate annual income which is used for the organizations' purposes. Only if an organization were not even using the investment income from its assets, or were holding large amounts of non-income-producing and otherwise unused assets, would the IRS ask questions about reserve levels.

Questions about apparently high levels of reserves are far more likely to come from those who support the organization financially: donors, members, students, or others. A donor who is asked to contribute to an organization that appears to already have sufficient resources for its needs might fairly ask why further contributions are still being sought. Members may question dues levels; students may ask why tuition is so high. (Faculty may press for increased compensation.) Organizations must be prepared to respond to such questions in a way that will convince the questioner that there is truly a need for additional resources.

Responsibility for Budget Preparation

The next concern is, who should follow these steps in preparing the budget? The preparation of a budget involves policy decisions. The treasurer may be the person best qualified to handle the figures, but is usually not the person to make policy decisions. For this reason, a “budget committee” should consist of persons responsible for policy decisions. Usually this means that either the board itself should act as the budget committee, or it should appoint a subcommittee of board members. The treasurer may, and probably should, be a member of this committee, but should take care not to dominate the process. In larger organizations, management will bear the responsibility for preparing the organization's budget. The board's role will be to challenge management's assumptions and resource allocations to make sure that they are reasonable and consistent with the organization's mission.

This doesn't mean that the detailed estimated cost studies and revenue estimates for various activities can't be delegated to staff members. In fact, they normally should be. But the final decisions as to what the goals are and their relative priority has to be a board-level function.

Take, for example, a private independent school. At first glance, there might not appear to be many board-level decisions to make. The purpose of a school is to teach, and it might seem that the budget would be a most routine matter. But there are many decisions that have to be made. For example:

1. Should more emphasis be placed on science courses?
2. Should the school purchase more sophisticated equipment to help teach computer science?
3. Should the school hire a foreign language teacher for grades 2–4?
4. Should the school increase salaries in the coming year and try to upgrade the staff?
5. Should the athletic field be resodded this year?
6. Should a professional fundraiser be hired?
7. Should the extracurricular music program be expanded?
8. Must tuition be increased? If so, how much?

These questions and many more face the board. Undoubtedly they may rely on the paid staff to make recommendations, but the board is responsible for policy and the budget represents “policy.” This responsibility cannot be delegated.

Allocating an Annual Budget to Monthly or Quarterly Periods

One of the best and easiest ways to allocate an annual budget into shorter periods is to first analyze the actual income and expense for the prior year, and then allocate this year's budget based on last year's actual expenses.

To illustrate, assume the church's income last year was $100,000 but is expected to be $120,000 this year. A budget for the new year could be prepared as follows:

In this illustration, we have assumed that the increase in income of $20,000 will be received in the same pattern as the prior year's income was received. If this assumption is not correct, then adjustment must be made for the anticipated income which will depart from past experience. For example, if it is anticipated that a single gift of $10,000 will be received in the first quarter and the other $10,000 will be received in about the same pattern as last year's income, the calculations to arrive at a new budget would be somewhat different, as shown below.

If, at the end of the first quarter, income of only $35,000 had been received compared to a budget of $43,000, it would be apparent that steps should be taken to increase contributions, or the church will fall short of meeting its budget for the year.

The expense side of the budget should be handled in the same way. Generally, expenses tend to occur at a more uniform rate, although this is not always so. In many ways the expense side of the budget is more important than the income side, since it is easier to increase expenditures for things that weren't budgeted for than to raise additional contributions. If the budget is regularly compared to actual expenditures for deviations, it can be an effective tool to highlight unbudgeted expenditures.

The more frequently year-to-date actual information is compared with the budget for the same period, the better able management and the board will be to respond to changing circumstances before small problems become big ones. If possible, the budget, and actual data, should be prepared on a monthly basis. If this proves to be too cumbersome, consideration could be given to quarterly or bimonthly budgets and statements. However, if the organization's cash position is tight, monthly statements become almost a necessity.

Illustrative Expense Budget

The Valley Country Club is a good example of an organization that has to be very careful to budget its income and expenses. While the club has a beautiful clubhouse and a fine golf course, all of its money is tied up in these fixed assets and there is no spare cash to cover a deficit. Accordingly, each fall when the board starts to wrestle with the budget for the following year, it is aware that it cannot afford the luxury of a deficit. Since the budget is so important, the entire board sits as a budget committee to work out the plans for the following year. The club manager, with the help of the treasurer, prepares a worksheet in advance of the budget meeting. This worksheet indicates the actual expenses for the current year to date, the estimate of the final figures for the year, and the current year's budget to show how close the club will come. The board, through discussion and debate, attempts to work out a budget for the coming year. Exhibit 1 shows the worksheet for the expense budget.

In looking at this worksheet, notice first that the expenses are grouped by major function so that the board can focus attention on the activities of the club. The alternative presentation would have been to list expenses by type—salaries, supplies, food—but this doesn't tell the board how much each of the major activities is costing. Knowledge of the cost of each activity is needed to know whether the club is making or losing money on them, so that intelligent decisions can be made about levels of charges to be made to members for participation.

There are three columns for the proposed budget—the minimum, the maximum, and the final amount. As the board considers each item, it records both the minimum and the maximum it feels is appropriate. No attempt is made at the beginning to fix a “final” budget amount. Instead, all budget items are considered, listed as to the minimum and maximum cost, and totals arrived at. It is only after all items have been considered, and only after a preliminary review of potential income has been made, that the board is in a position to make judgments.

After the board has completed this worksheet showing final figures for the year, the next step is to break down the budget into monthly pieces. As with many organizations, the Valley Country Club's expenses (and income) are seasonal. In this case, the budget is broken down into monthly segments, assuming that the expenses will be incurred in the same pattern as expected for the current year, in the manner discussed earlier.

Importance of Budget Comparison

The internal financial statement should also show the budget, and for the same period of time. Interim figures for the three months cannot easily be compared to budget figures for twelve months. The budget must also be for three months. Last year's actual figures for the same period, and the current full-year's budget, may also be shown if that is considered helpful. However, the more information a reader of a financial report has to absorb, the greater the chance that added information could detract from, rather than help, the reader's understanding of the information presented.

Exhibit 2 shows the Valley Country Club Statement of Income and Expenses for both the month of June and for the six months, with budget comparisons to highlight deviations from the budget.

This financial statement gives the reader a great deal of information about the club's activities for the two periods. It should have the effect of alerting the reader to the fact that unless something happens, there may be a deficit for the year. For example, instead of having a small excess for June, there was a deficit of $6,240, and instead of having an excess of $7,500 for the six months, there was a deficit of almost $5,000. The board member reading the statement should be concerned about these deviations from the budget. This form of presentation makes it easy to see deviations. Unfavorable deviations can be quickly pinpointed and the reasons for them can be explored to determine the action that must be taken to “make up” (if possible) for their effects and to prevent their recurrence.

Notice that both the current month and the year-to-date figures are shown on this statement. Both are important. The monthly figures give a current picture of what is happening, which cannot be learned from the six-month figures. If only the six-month figures were shown, the reader would have to refer to the previous month's statements showing the first five months to see what happened in June. Likewise, to show only the month, with no year-to-date figures, puts a burden on the reader. Some calculating using previous monthly statements would be required to get a total and see where the club stood cumulatively. Year-to-date budget comparisons are often more revealing than monthly comparisons because minor fluctuations in income and expenses tend to offset over a period of months. These fluctuations can appear rather large in any one month.

Alternate Presentation

Restaurant income and expenses have been shown “gross” in the statements. It would be equally proper for the club to show net income for the club before the restaurant operation was considered. Here is how this would look.

Another possibility is to show only the net income of the restaurant in the statements, perhaps in the income section. In condensed form, here is how the statements would look.

Either presentation, or the one in Exhibit 2, is acceptable. The appropriate presentation depends on the importance of highlighting the restaurant activities.

Variable Budget

One technique that is often used in budgeting an operation where costs increase as the volume of activity increases is to relate the budgeted costs to income.

For example, the final expense budget (Exhibit 1) and the relationship to budgeted income for the restaurant operation is as follows:

If all costs increase proportionately as income increases, it is a simple matter to create new budget figures each month based on actual income. Using the six-month figures shown in Exhibit 2, our budget comparison for the restaurant activity for the six-month period would look like this:

^a Original budget for six months.

^b 85% of actual income for the six months, based on the relationship of budgeted expenses to budgeted income as shown above.

The significant observation here is that while the original budget comparison in Exhibit 2 showed an unfavorable deviation from budget of only $4,150, the unfavorable deviation using this variable budget is significantly higher, $13,925. If the variable budget is accurate, the club manager has not been watching costs carefully enough.

The financial statements would show only the variable expense budget. The original expense budget would not be used. This kind of budget is more difficult to work with because each month the treasurer or bookkeeper has to recalculate the expense figures to be used based on actual income. At the same time by doing so, a more meaningful budget comparison can then be made. It would be very difficult otherwise for the board to judge the restaurant's results.

One final observation about this variable budget. Certain costs are not proportional to income. For example, the club cannot have less than one bartender or one chef. Accordingly, in preparing a variable budget sometimes the relationships that are developed will not be simple percentage relationships. For example, perhaps the relationship of bartender salary will be, say, $5,000 plus 5% of total income over $75,000. If so, then if restaurant income is $350,000, the budget will be $18,750 ($5,000 + 5% of $275,000).

Narrative Report on Deviations from Budget

Much of the detail shown in the budget (Exhibit 1) has not been shown on the interim financial statement (Exhibit 2). If the board felt it appropriate, supporting schedules could be prepared giving as much detail as desired. Care should be taken, however, not to request details that won't be used since it takes time and costs money to prepare detailed supporting schedules, even when the mechanics of preparation are done by computer.

It may be that a more meaningful supporting schedule would be a narrative summary of the reasons for the deviations from budget for the major income and expense categories. The club manager, in the case of the Valley Country Club, would probably be the one to prepare this summary. It should then be reviewed by the treasurer prior to the full board meeting so that questions that are likely to be asked in that meeting can be anticipated and answers obtained. The amount of detail and description that might be put in this summary would vary from account to account. The report should discuss only reasons for the major deviations. This report should accompany the financial statements so that questions raised by the statement are answered immediately. Exhibit 3 is an example of the type of summary that might be prepared to explain the expense deviations from budget (in part).

This type of report can be as informal as you want to make it as long as it conveys why there have been deviations from the original budget.

This deviation report should be in writing, both to ensure that the board knows the reasons and to force the club manager to face squarely the responsibility to meet the projected budget. This report is a form of discipline for the manager.

Action by the Board

The best-prepared budget serves little purpose if the board is unwilling to take action once it becomes apparent that expenses are exceeding budget or that income has not been as high as anticipated. To be useful, the budget must be a planning device that everyone takes seriously. There must be follow-up action.

The type of reporting discussed in this chapter will give the board information on where the plan is not being followed. However, the board must be prepared to take action when the deviations indicate the existence of serious problems. Perhaps all that will be necessary is for the board to discuss the budget deviations with the club manager. A club manager who knows that the board fully expects performance within the budget will take appropriate action. If some matters are beyond the control of the manager, he or she may suggest alternatives to the board for its action.

The board must be prepared to take action to modify its plans if it becomes apparent that the budget cannot be met. If the organization has substantial resources to fall back on, it can afford to accept some deviations from the original budget without serious financial consequences. For most organizations, this is not the case. The board must be willing to face unpleasant facts once it becomes apparent from interim financial statements that corrective action must be taken. Many budgets fail, not because there is not enough information available to the board, but because the board fails to take aggressive, corrective action. In these instances, the board is not fulfilling its responsibilities and the budget is a meaningless formality.

Suggested Procedures

There is no “standard” way to go about preparing a five-year plan. Probably the best way to start is to set up a committee of, say, three persons. The persons chosen for this five-year planning committee should be persons who are in policy-making roles within the organization. There is little point in putting a person on this committee who is not both knowledgeable and influential within the organization. Otherwise the resulting document will be of relatively little value to the organization.

Illustrative Master Plan

The result of this whole process is a master plan that should guide the board in its planning. It should be reviewed at least every year or two and should be updated and extended so that it represents, at all times, a five-year plan for the future. Exhibit 4 shows an example of a simple master plan for the Center for the Development of Human Resources. The Center for the Development of Human Resources exists to help individuals “grow” through interaction in study groups. The center has a professional staff organizing and running programs, which are held in a rented building.

Note that on this master plan the center has indicated future expenses not in terms of the type of expenses (salaries, rent, supplies, etc.), but in terms of the goals or objectives of the organization. This distinction is important because the center pays its expenses only to further some goal or objective. Thus, in a master plan it is entirely appropriate to associate costs with each goal or objective. This means that a certain amount of allocation of salaries and other costs between goals will be necessary.

Another observation is that the format of this master plan did not start off with the traditional approach of showing income and then deducting expenses. Instead, the goals or objectives were stated first, and only after the organization agreed on what it wanted to do did it start to work on how to raise the necessary income. This point has been emphasized because the organization does not exist to raise money and pay expenses; it exists to accomplish certain objectives, and unless these are spelled out clearly and are constantly kept in mind, the organization may lose sight of the reason for its existence.

No attempt was made in this master plan to balance the amounts of income and expense except in a general way. In each year, there is an indicated surplus. This recognizes that while the board has made its best guess as to how it will raise its income, there are a great many unknowns when working with a five-year budget. As each year passes and this five-year plan is updated (and extended), the sources of income will become more certain, as will costs, and these figures will be refined and adjusted. The important thing, however, is that the board has set down what it plans to do in the future, and how it now expects to be able to finance such plans.