Beating the budget cycle: confront the economy's inevitable ebb and flow, and come out on top.

WHEN ECONOMIC DOWNTURNS REDUCE household incomes and lower confidence in the economy, nonprofit organizations face especially troubling times. Contributions to charitable organizations decline because individual, corporate, and foundation donors are less inclined to give; people have less money to spend on association dues, products, and services; and earnings from endowments and reserves shrink along with their capital market values.

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Every association's future is to some degree always uncertain and subject to good and bad surprises. During economic downturns, however, an association is particularly vulnerable to losses and missed opportunities for gain because its financial and human resources are especially tight. Any cushion an association may have built--perhaps in the form of an impressive reserve fund--will provide only temporary relief. And if an association taps its reserves without first taking a hard look at updating its business model, the funds only delay the changes required for long-term survival.

With the cyclical nature of the economy, it is hard to believe that some executives are caught by surprise when a confluence of external events leads to downward pressure on associations' budgets. Taking steps to better protect against economy-related financial stress will ultimately serve the association well in good times and bad. Such steps include the use of risk management as a framework to manage fiscal surprise.

Developing a risk-management mind-set

Risk is a measure of the probability that the future will be different--much worse or much better--than association leaders expect. Executives can use risk management not only to protect themselves and their associations against catastrophe, but also to navigate their organizations through economic downturns. Risk management is both a way of thinking and a way of acting. It allows association leaders to anticipate and respond to surprises so that organizations can preserve all that they have achieved and capitalize on unexpected opportunities.

Hard economic times make good risk management especially important to an association's short-term survival and ongoing mission fulfillment. Sensitivity to the inevitable element of surprise begins with paying attention to early warning signs.

Heeding the warnings

Beginning as early as 2000, the U.S. stock market declined steadily. The Dow Jones Industrial Average dropped from 11,357 in January 2000 to 8,607 in January 2003. Although unfavorable market forecasts dominated the news, too few association leaders heeded the economic indicators, beyond taking a closer look at their retirement portfolios. Was this information reflected in finance meetings when your association's budget was being discussed?

In "Strategy Under Uncertainty," an article in the Harvard Business Review on Managing Uncertainty (1999, Harvard Business School Press), authors Hugh Courtney, Jane Kirkland, and Patrick Viguerie describe uncertainty as existing along a continuum. At one end is minimal uncertainty due to the availability of clear trends and data that managers and leaders can harness for decision making. At the opposite end of the continuum is an area of residual uncertainty--the domain of the "unknown unknowns."

Somewhere in the middle is the land of the "unknown but knowable," where data are available but regularly ignored by managers and leaders. Observing, documenting, and acting on such signs are essential to avoiding fiscal crisis. Following are a few areas in which to look for warnings:

Corporate stock prices. If you receive funds from a foundation affiliated with a corporation, be aware of how much of the foundation's assets are invested in the company's stock. If the foundation's fiscal health is tied closely to that of the corporation, keep a close eye on the stock price.

Consumer confidence indices. As consumers' confidence falls, so do their donations and perhaps even their payment of membership dues, particularly if dues are paid with personal funds.

Industry earnings. Corporate earnings within the industry that you serve are an indication of how much your members and others will spend on your offerings. For example, companies looking to cut budgets spend less sending employees to conferences.

Paying attention to these and other indicators allows you to fine-tune your revenue projections more frequently. You can then look for ways to cut costs accordingly--before it's too late.

Assessing investment strategies

For decades association board members and financial advisers to nonprofit organizations have touted the importance of achieving a diverse funding mix as the number one strategy for maintaining fiscal health and stability. As the tune is sung at countless board meetings each year, having many revenue baskets protects an association from being dependent on any single source of revenue.

But what happens if a down economy negatively affects most or even all of your revenue sources? It is vital to understand that while still a good idea, a diverse funding mix doesn't insulate associations from potential budget deficits. The Nonprofit Risk Management Center, Washington, D.C., has an example that proves this. We achieved our ideally diverse funding mix by the late 1990s. Our funding at that time consisted of private grants (40 percent), corporate donations (10 percent), and income from the sale of a variety of products and services to other nonprofit organizations (50 percent). With a self-congratulatory attitude, we looked forward to continued financial and programmatic growth.

But as the national economy worsened, we watched in horror as the assets of a major foundation funder plummeted and its division that had dispensed several large grants to the center was quickly liquidated. That foundation contributed about 10 percent to our budget. Fortunately, even in the midst of its turmoil, the foundation committed to funding us for two years; so we had time to make adjustments. But to make matters worse, in a rather short time period, we saw a large number of our nonprofit clients slash their budgets for product and service purchases. We addressed the daunting economic situation in several ways.

Tapping new markets. We took a hard look at our broad income categories and determined which segments were poorly performing. This analysis enabled us to adjust our marketing to focus on the types of clients still able to afford our services. For example, we offer consulting services to nonprofit organizations, many of which could no longer afford such services. Insurance providers, on the other hand, were thriving because of the hard insurance market. Therefore, we were able to increase sales of our risk-management materials to that market segment. Better yet, because the insurance providers then made the materials available to various nonprofit organizations, we were able to stabilize our budget without totally abandoning the small and mid-size nonprofit groups that have come to rely on our free and low-cost services.

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Seeking new funders. Increased sales of risk-management materials, not surprisingly, did not make up for the 10 percent loss in funding from the foundation. We used the two years before the funding ended to seek new grants from other foundations in industries that had not experienced major economic setbacks. We made up about half of the shortfall this way.

Slashing the budget. We made up the other half of the shortfall from sheer cost cutting. We looked at every possible line item and achieved savings in areas ranging from reducing staff hours to dropping organizational memberships.

Appraising income risk

The center's experience illustrates a nonprofit organization's income vulnerabilities. Income-related assets may be at risk from

* declining membership dues;

* loss of interest in the association's products and services;

* changes in focus or interest by grant-making foundations on whose support the association has grown to rely;

* loss of corporate support, fees, and advertising income; and

* loss of income from investments.

Various tools are available for appraising income risk. Although no tool or method is foolproof or complete, each can stimulate further thought on the part of association managers and leaders, who are best equipped to critically examine the relationship between income risks and their particular association's mission-fulfilling activities.

Questionnaires. Develop a survey that asks questions about various income categories, such as

* the average rate of growth or decline during the past 5 or 10 years for the various revenue generators;

* the fastest growing revenue category for the association;

* the association's revenue mix; and

* the most substantial changes to the mix in recent years.

Use the questionnaire to seek the views of senior staff about prospects for growth or decline in key revenue categories. For example, questions in the dues revenue section of the survey might include

* What have been the association's membership acquisition and retention rates each year for the past 10 years?

* What rates are projected for the next two years, and on what information are these predictions based?

In the nondues revenue section, questions might include

* During each of the past five years, what nondues income categories have produced the most and least net income?

* What nondues income categories offer the greatest potential for growth?

Loss analysis. While the term loss analysis traditionally refers to a review of past accidental losses, in the context of income risk, the term means an in-depth review of instances in which the association's income fell short of projections that had been made with a high degree of confidence. This process involves more than simply calculating the budget variance. To the extent possible, staff should identify the reasons for each loss and the likelihood that loss conditions and circumstances will continue.

For example, consider this hypothetical scenario: Membership dues income declined by 10 percent in 2003. In analyzing the loss, staff determines that two major factors contributed. First, the members of the small industry council decided to form a separate association, and most dropped their membership. This event resulted in an 8 percent attrition rate. Second, several large mergers occurred within the membership, resulting in a 2 percent membership loss. The staff believes that mergers will continue during the following year, but that the organization will not lose any more members to the new association.

Financial statements. Associations spend a great deal of time developing accurate financial statements, yet these documents are too infrequently used as a tool for understanding income losses. To be used for this purpose, the statements may need to be formatted differently. Try breaking down broad income categories on the reports shared with the board into subcategories that enable staff to pinpoint the source of loss. For example, a board report might show a drop in conference registrations. A closer analysis might show that the drop came primarily from the nonmember subcategory.

Other association documents. Minutes of past board or planning meetings may reveal helpful information for analyzing income losses and predicting future patterns. For example, meeting notes may show instances in which budget dollars were redirected to special advocacy, recruitment, or marketing campaigns. Or documents may reveal instances in which the board discussed member concerns of complaints. In hindsight, these concerns may have foreshadowed income losses in the dues and products and services categories.

Rethinking budgeting

During the past two years, countless association executives have found themselves in the difficult position of explaining to finance committees and boards the reasons why certain revenue categories have failed to live up to budgetary expectations. (See sidebar, "Communicating Financial Loss to Your Board.") After holding a national convention that attracted only 80 percent of the delegates who participated in the prior year's event, the executive director of one organization explained to her board that the poor economy made it impossible for many of the association's members to attend. Yet that same executive was well aware of downward economic indicators before the ink on the conference budget was dry. Regardless of current indicators, the tendency at many associations remains to project growing income for activities such as conference registrations, book purchases, corporate support, and fees for services--even in the face of evidence that revenue generation from these categories will be less.

With recent discussions about nonprofit CEOs and chief financial officers certifying financial statements, perhaps a different approach to budgeting is in order. Following are two alternative frameworks for budgeting that may foster more risk-aware decision making:

Focus on revenue first. Many managers start budgeting by adding new activities, estimated pay raises, and new staff positions to last year's budget to determine what it will cost to run the association for the coming year. Here's the danger in that process: Because managers have added expenses for the coming year, they'll automatically increase projections in several revenue categories to balance the budget. An alternative is to begin the budgeting process with the revenue side of the budget.

At smaller associations, the chief staff executive may lead this initiative; at larger organizations, the chief financial officer or budget director may spearhead the effort, relying on staff to provide accurate revenue projections. For each revenue category, have the staff articulate how it developed its predictions. For example, an explanation might read, "We estimate a 10 percent drop in membership dues revenue due to the recent launch of a competitor association that is trying to draw members away by offering complimentary first-year memberships." Or staff might explain, "We anticipate a 10 percent increase in exhibit revenue because we are raising the price by 10 percent, and in a survey of past exhibitors, 100 percent indicated that they would continue to exhibit if the price was increased by that amount." Once staff articulates the rationale behind the revenue predictions, present the revenue side of the budget to the finance committee or full board for comments and approval.

Next have the staff develop the expense estimates for the coming year by carefully examining what core operations cost and what programs will be pared back to accommodate new initiatives. For example, an association might decide to add Web seminars to its menu of educational offerings but doesn't expect revenues to match expenses during the first year, with a projected net loss of $2,000. Therefore, to make up for the loss, staff decides to reduce the number of times per year that it prints the newsletter, which will save $2,000.

A common mistake in budgeting is to ignore the need to curtail the old when making way for the new. This gives the board the false impression that along with all of the new initiatives it has embraced, the association will continue to deliver long-standing programs and services.

Focusing on expenses first only encourages budget planners to inflate revenue numbers. On the other hand, focusing on revenue first represents a necessary change in how organizations approach budgeting.

Present multiple scenarios. A second approach to budgeting is to use different contingencies or contrasting views that reflect the effect of various potential events and developments. For example, budget projections for membership dues might include the following scenarios:

Projected revenue: $500,000. Explanation: This figure represents a modest increase of 2 percent over last year's results, based on the fact that the association has averaged 2 percent growth in membership dues during the past 10 years. Confidence level: 70 percent.

Alternative one: $400,000. Explanation: This figure is likely if the small industry council moves ahead with its plans to spin off from the association. Confidence level: 20 percent.

Alternative two: $600,000. Explanation: This figure is likely if the new campaign headed by the outsourcing firm ABC Group achieves all of its goals. Although the cost of the campaign is $125,000, it seeks to enroll long-term members. Confidence level: 10 percent.

Note that the percentages for confidence level are educated guesses. To arrive at them, staff should ask, "If we were betting, what is the likelihood of this scenario occurring?" This question stimulates discussion and forces staff to look closely at all of the facts available to them so that they can come up with the best answer. The basis for that answer may not be entirely empirical, but some executives fail to consider the question of probability at all. Likewise, when boards hear projections that are based on best-case scenarios, they seldom ask questions regarding likelihood. With information such as that provided in the scenarios example, the board or finance committee can conduct a thoughtful discussion about the association's strategic approach to the possible spin-off of a major constituency as well as the economic feasibility of a costly new membership recruitment campaign.

Developing multiple scenarios brings risk-management principles into the budgeting process. While not as imperative as focusing on revenues before expenses, it can be an extremely valuable tool in budget planning.

Creating a mission-focused future

Economic downturns bring both threats and opportunities to which a resourceful association can respond constructively. Many association leaders would prefer to leave a bad spell behind them and look optimistically at signs of a reviving economy. However, taking time to re-examine long-standing approaches to budgeting and to assess the reasons behind historical income losses will serve the association well in good times and bad. Fortified with a wide-angle lens focused on the association's financial future, the management and leadership team has the strongest chance of avoiding fiscal surprise and realizing the mission-focused future it envisions.

RELATED ARTICLE: Communicating Financial Loss To Your Board

BY KARLA B. HIGNITE

Communicating unfavorable financial results to boards of directors is not the easiest task for association executives; nevertheless, they must keep volunteer leaders up to date on such issues. Following are some suggestions for effectively communicating financial losses to boards of directors, as suggested by Jack Hampton, executive director of the Risk and Insurance Management Society, New York City, and Jim Hirt, executive director of the Public Risk Management Association, Alexandria, Virginia.

1. Communicate losses promptly. If you communicate on a regular, monthly basis, your board should be well informed of the financial status of association programs, says Hirt. But when unexpected losses occur, he recommends immediate notification to your board chair and treasurer, followed by notification to the full board.

Hampton concurs. "Immediately after learning about program losses, association executives must gather information as to the extent of losses along with a full explanation of the causes and the plan going forward," he says.

2. Offer details on the losses. As for program and product losses, an association's board needs an accurate description of the extent of the variance along with enough detail to understand the cause of any losses, says Hampton. "The major danger is in not telling the full story so that board members can understand the causes of variances or down cycles."

3. Be ready with a plan. One mistake association executives might make is to deliver bad news without having a plan to reverse the negative trend. "Your board also needs to know of your plan to mitigate similar losses in the future," says Hampton.

4. Communicate directly. Hampton advises communicating losses in person or by telephone to your board chair, followed by a written presentation to the full board.

"Board members need honest, direct [explanations] for fiscal problems," says Hirt. "Good or bad, right or wrong, if they hear it from the association executive first, they will trust what they hear and will also be more willing to accept staff suggestions for resolving the problem."

Building a sense of trust with your board and working as a team are key to preventing financial setbacks from turning into crises, says Hirt. "Association executives and boards must view the financial responsibility not [solely] as a staff, committee, or board responsibility, but as the responsibility of all three," he says. Only then will associations avoid the many fiscal pitfalls that may occur.

Karla B. Hignite is a freelance writer based in Colorado Springs, Colorado.

E-mail: [e-mail].

Melanie L. Herman is executive director and George L. Head is special advisor at the Nonprofit Risk Management Center, Washington, D.C. They are coauthors of Managing Risk in Nonprofit Organizations: A Comprehensive Guide (2004, Wiley & Sons). E-mails: [e-mail] and [e-mail].

PHOTOGRAPH BY ROBERT BURKE