Fixed Costs and the Not-for-Profit

Most not-for-profit organizations (not to be confused with not profitable organizations) rely on three sources of funding: endowment income, corporate contributions and individual contributions.

To focus on the fixed costs aspect of this topic, let’s say the organization is a church with no endowment. It won’t receive corporate contributions, and so it must rely on individual contributions (and a few fund raisers) for its income.

And just for fun, let’s say a generous member decides to make a one-time gift of $20,000.

What could the church do with such a gift?

They could start an endowment fund, not touch the principal and use the income from the fund each year. They could pay off a chunk of the mortgage on the church building, or remodel the church kitchen. The uses are endless, but I’ll bet large amounts of money that among the alternatives, a great groundswell will arise for using the money to pay staff. The proposal might take the form of increasing staff wages or benefits; it might instead focus on increasing hours worked.

Staff salaries aren’t exactly fixed costs. Salaries and benefits can be reduced. Staff positions can be eliminated or have their hours cut back. Salaries in particular are referred to by economists as “sticky downward.” That is to say, there exists a great reluctance to reduce nominal salaries. When times are good salaries go up, but when times are bad they do not go down as quickly. Given bad enough and long enough times, salaries will decline.

Back to our $20,000 largess. Let’s say we’re in a more reasonable interest rate environment than today and can expect to safely earn 5% on our money. The $20,000 will spin off $1,000 a year. The church could afford to increase salary and benefits by $1,000 bucks because that’s the income the $20,000 will generate each year. Income and Expenses would increase by the same amount.

Big whoop. This won’t satisfy anyone.

However, applying any greater amount of the one-time largess to the sticky downward costs of employee compensation means the church is eating into the $20,000, and at some point the well will run dry. When it does, the church needs to find a new source of funding or enter a painful (and often hurtful) process of cutting compensation and/or hours.

In a church that is growing and needs additional staffing to help it grow, it could be reasonable to spread the $20,000 out over (say) four years. This method implicitly challenges those who are getting the additional compensation to add enough value to the church that at the end of the four years congregants will in the course of normal business be kicking in an extra $5,000 to keep the higher staffing levels. However, if that is the case, it is important to not take increased contributions as they come in and apply them to something else.

If they do apply increases in contributions in years 1-3 to something else, they’ll find themselves in the same position I did in 1984 with my fixed costs rising substantially through a number of individually reasonable decisions. [See: earlier post ] In the church example, at the end of four years the $20,000 is gone, and for the next year they need to replace $5,000 of income.

This scenario crops up a lot in churches under various guises. Sometime it is a one-time unrestricted contribution as in the scenario just discussed. Sometimes it’s a surplus from a previous year. Sometimes it is money pledged to match increased contributions.

The last case is a bit trickier. The assumption is that when parishioners increase their pledges because of a special match, they will maintain the new, higher level of giving in the future. For many people that is the case (contributions are somewhat sticky downward) and so applying those higher pledges to increased fixed costs can be (mostly) justified.

However, the generous match is a one-time offer and churches should treat it as such—at least that’s my opinion. What’s yours?

P.S. Happy birthday to my dog, who turns 10 today.

Fixed Costs and the Housing Market

In 1987 the privately held company I worked for sold out to a much larger corporate competitor. I was in a mid-level position and required to own a certain level of stock. I voted against the acquisition. I thought I would have more opportunity with the smaller company where I had been promised a particular higher position a year hence.

Didn’t matter, the old guys (and it was almost entirely guys back then) had the shares and they voted their wallets and we sold out. (Oh, they officially called it a merger—they usually do—but when one side controls all the subsequent decisions, it’s a merger in name only.)

The good news was that I made a hefty profit on my stock, and didn’t have to maintain any level of ownership in the acquiring company. As a result I had some free cash.

Interest rates were high (in the 9-10% range), the stock market had been on a tear and one of my friends and I decided the best thing we could do with some of the money was pay off our mortgages. Not everyone agreed. We had another co-worker and friend who thought the best approach was to use the stock sale windfall to trade up in houses. He figured he'd use the money as a down payment, combine that with the profit he had in his house (the housing market was booming then) and get a really big, expensive house.

His analysis showed that he could afford the mortgage, with the additional down payment, it would only increase 25% from current levels, and with raises and expected bonuses he could cover the increase.

But, he didn’t think about (1) the additional real estate taxes (2) the increase in property insurance costs (3) additional maintenance costs that come with a bigger house, and (4) the house he wanted was farther away from work, so his commuting costs and time would both increase.

Lastly, he would have no cushion. If the business had a bad year and bonuses declined he was in trouble—and our business was cyclical.

During that whole time I joked with my finically conservative friend that if I took on that much risk, I couldn’t sleep. He said, if our other friend took on that much risk, he couldn’t sleep.

Given that, we sat our friend down and talked him out of his proposed house purchase. Back in 1987 our friend was “out there” on the risk frontier.

Twenty years later, huge portions of the United States shared his risk tolerance and we narrowly avoided a depression as a result.

~ Jim

Controlling Fixed Costs (a Personal Experience)

For the first few posts I will discuss Fixed Costs versus Variable Costs. To define the terms, fixed costs are those that come due regardless of what income you receive. A mortgage is a fixed cost. If you lose your job, the mortgage payment still must be paid. Income taxes are variable costs – no income, no income tax.

Many, many years ago I got promoted and moved from the Boston area to the greater NYC area. While in Boston, I started a night school MBA program at Boston University. For a variety of reasons I couldn’t finish the program in New York. I decided I wanted to return to BU full-time for one year and finish my MBA. Great in theory, but could I afford it?

Each year I developed and followed decent budgets. Even with two growing children and a stay-at-home wife, we spent less than we earned. We knew we had to save for the kids’ college and our retirement.

With the idea of taking a year’s leave of absence, I developed a budget assuming $0 income. On the expense side I deleted all variable costs – those we could forgo for the year. I was shocked to discover that my fixed expenses were considerably higher than my gross earnings had been before my move from Boston four years earlier. How did that happen?

We were living within our means. We had no credit card debt. No car loans. But,

• We bought a more expensive house, so the mortgage, real estate taxes, insurance premiums and upkeep all increased.

• We traded in two older cars for newer cars. We paid cash, but auto insurance costs grew significantly.

• We had two children, who thought they should eat and have clothes and go to the doctor.

• We enrolled the older child in pre-school, which we now thought of as a necessity.

It’s not that we couldn’t afford each of those decisions, but each came with fixed costs attached, and over time the fixed costs added up. Fortunately, my company offered me part-time employment while I studied in Boston, which also covered medical insurance. That was enough to make the deal affordable without taking out student loans.

I was certainly fortunate to be able to go to school without going into debt, but I had learned an important lesson from the exercise. From that point on I made sure I understood not only the short-term implications of every buying decision, but the long-term ramifications.

~ Jim