The overall objective is cost-effective use of resources.
Evaluating Individual Programs
Surplus/Deficit (Profitability) Analysis and Service Cost
Be careful about using any information that purports to show whether an individual activity (department, program, location, etc.—sometimes referred to as cost "objects") is covering its costs. Any surplus or deficit information that is drawn directly from public financial statements or the nonprofit's financial accounting system is likely to employ allocations of certain costs that can actually mask an activity's true financial health.
To determine whether an activity—for example, a particular service offered by the nonprofit —is breaking even, you need to assess what it costs to provide that service. There are many different methods that are used to develop a service cost, and each has certain strengths and weaknesses.
There are several terms that are relevant to this analysis—"direct costs," "indirect costs," "overhead costs," and "lumpy costs."
- "Direct costs"—these can be directly associated with a single activity and can feasibly be traced back to that activity. For example, the salary of a child care worker in a nonprofit with many types of social services in different locations could be directly attributed to "Child Care Department" or "After School Services" or the "River City Facility." The offering of that service in that location causes the nonprofit to incur the salary cost.
- "Indirect costs"—these are shared costs that are incurred in the operation of multiple activities, or costs that are directly associated with a single activity but that cannot feasibly be traced to that activity. A typical example of a cost that is viewed as indirect is payroll processing, which may be considered indirect for both of the reasons cited: it is a cost that is incurred by all activities in the organization, and it may not be cost-effective to precisely trace the additional payroll processing cost caused by each employee's services each pay period.
- "Overhead costs" is a term subject to considerable variation. It can be loosely applied to all costs except direct costs—which make it interchangeable with "indirect costs" —or applied to just that small portion of total costs that is unaffected by any specific activities in an organization. Examples of such overhead costs are general administration (the executive director's office space, basic legal and audit/accounting costs of organizing and maintaining a nonprofit, and costs of convening meetings of the board of directors and publishing annual reports). A slightly broader definition of overhead in the nonprofit accounting world includes all "supporting activities"—encompassing general administration and fundraising costs.
- "Lumpy costs"—those which do not increase smoothly as one provides more service. Although it sounds colloquial, the idea is actually a powerful concept used in costing research! We see lumpy costs when we look carefully at how the level of costs in some organizations increases as the level of service provided increases. When costs are lumpy, they tend to exhibit an initial economy of scale—with unit costs declining rapidly with increases in volume—and then suddenly jump upward when some existing capacity limit of equipment, staffing, or facilities is reached. At that point, the organization has to make a major addition to its "fixed" capacity, and average unit costs are high once again. If the volume of service grows, unit costs will tend to decline once again over time—until the next time that capacity is exhausted. Lumpy costs are also said to behave like a "step function." (See Horngren, 337-339.)
The important point about a service with lumpy costs is that the cost of providing service may not be captured well with a single, average dollar figure. The effective cost to the organization of even a small increase in service level may vary wildly depending on how close it is to exhausting the capacity of one or another input, the size of the lumps, whether the service is growing or shrinking, whether the cost of lumpy inputs is changing - and how quickly.
Alternative Service Costing Methods
With all costing methods, direct costs are included in the computation of a service's cost. Any costs that are completely attributable to a given service, and can be feasibly measured, should be the first element in its service cost.
The treatment of lumpy direct costs, as well as indirect and overhead costs, are more problematic. If they are a relatively small proportion of the total costs under consideration, you can calculate a "full cost" in the way that is suggested in the Bridgespan paper. This full cost method allocates a portion of the indirect and overhead costs to each of the individual services of a nonprofit, and adds the direct and allocated costs together to arrive at "the" average cost per unit of a service. This method has the distinctive advantage of simplicity, but it can result in a unit cost figure that is too high - and cause managers to put the brakes on options that would be cost-effective given any "sunk" costs that have already been incurred and that cannot be saved in the near term. (See Horngren and Chabot Space and Science Center example>.) With lumpy costs, the full cost method could also result in a cost per unit that is too low.
Other costing methods that handle lumpy, indirect, and overhead costs with more subtlety are better suited to nonprofits that have major fixed costs (labor contracts or other long-term employment agreements, long-lived equipment, facilities, owned land and buildings, large overhead) or offer service on a "multi-part" basis; e.g., one fee for entrance to a museum, another for attendance at a particular program.
While the full cost method has the distinct advantage of "objectivity," the incremental cost method requires more detailed analysis and judgment. The objective is to characterize the "cost structure" of the overall organization and its individual programs of interest. The discussions in Porter and Horngren suggest criteria for identifying the key cost drivers in an organization. Such an understanding can help you identify ways that the organization can reduce costs by downsizing, reallocating resources, or redesigning its offerings or operations.
Additional methods for discerning the cost structure of an organization are described in Horngren (328-335).
- Other costing methods such as activity-based c osting (ABC) represent a mid-ground between a full bottoms-up approach (e.g., incremental costing) and a tops-down approach (e.g., full costing). A typical ABC analysis allocates indirect costs in a tops-down manner, but distinguishes four layers of costs and uses multiple allocators to more closely mimic the cost structure of an organization.
- Used extensively in larger businesses, ABC has the advantage of a "formula" approach while being considerably more versatile than simple direct or full-cost methods. However, ABC tends to require a major investment of time and effort to develop—and we therefore don't recommend a full-blown ABC analysis for ACT project teams.
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The key to the project is to understand the organization's finances. There are at least two substantially different approaches to analyzing costs—"top-down" and "bottom-up." Using both, at least to some degree, is helpful to identify any errors or omissions in the cost analysis or source documents.
Problem Definition—It may seem logical to view a project as a straightforward matter of finding ways to reduce costs. However, it is generally more useful to recast the problem as one of better managing costs—cost reduction alone may not be the best approach to achieving financial and organizational health. Paring dollars from the budget is only desirable if the dollars saved exceed any value or income lost.