“That damn composer Wagner. He wrote all those pieces for big orchestras. Didn’t he ever think that 123 musicians might be a little hard to pay, especially in this recession? Let’s cut it to 50, the audience will never notice . . .”
Okay, maybe symphony orchestra directors don’t talk like scheming street vendors. They have the same problem a lot of organizations do — fixed costs. When Wagner wrote his symphonies he was thinking about the soaring beauty of violins and the mellow tone of a cello, not how he could cut corners. A symphonic orchestra with 123 musicians creates a substantial payroll. And, cutting it to 50 makes it a chamber orchestra. How do you cope?
If all other costs besides fixed costs are in line there is only one answer — boost revenue. The problem is that unlike cutting expenses, raising revenue takes time, often lots of time. Either new revenue streams must be developed or existing streams have to be boosted. So the first step is to constantly manage your fixed costs.
Unlike discretionary items, fixed costs are accepted from the beginning, often in the form of a formal agreement with an outside party. A frequent hallmark of fixed costs is a written agreement of some sort that was entered into by the organization and an outside group or groups. At the time these agreements might not be regarded as fixed costs, which is why they are often overlooked until budget trouble looms.
“Fixed” does not mean unchanging forever. Generally, fixed costs are described in a time-limited context, such as a year or so. This is done because ultimately all costs are variable. The implicit question to be answered is how long a fixed cost should be considered as fixed. This is why the fiscal year is as good a cut-off point as any.
Fixed costs are everywhere in your budget. Below are various types of fixed costs and suggestions on how to manage them.
- Building Rent. Building rental costs are classic examples of fixed costs. Office and program space are usually large enough needs that they will be secured for years at a time. Landlords will try to include inflation clauses or similar provisions such that any given lease amount is likely to be increased the next year according to a pre-agreed-upon formula.
- CEO Salary. Technically, the CEO’s salary is a fixed cost. The CEO might get expense reimbursements or perhaps some form of incentive payment, but it’s the “base salary” that counts as fixed.
- The Yearly Audit. The yearly audit that medium to large nonprofits must undergo is a clear example of a fixed cost. Auditors have a scope of work that they must cover to be able to render an opinion about the viability of the audited organization during the next 12 months. They typically offer that opinion in a format that is almost entirely proscribed by industry auditing standards. By contrast, special investigations or one-time tests would not ordinarily be considered part of the audit’s fixed cost.
- Fixed Assets. There is an entire species of assets known as fixed assets that are really fixed costs. These can range from a vehicle (or a fleet of vehicles) to large pieces of equipment. Buildings, of course, are in many ways the epitome of fixed costs — with one exception that also holds true for certain other assets. That exception is operating costs. Buildings are a fixed cost whether owned or rented, but their operating costs such as heat, air conditioning and water and sewer charges are technically variable costs (as many in the Northeast discovered this past winter when costs for snow and ice removal exploded ages-old records).
- Borrowing Costs. Any time a nonprofit borrows money to invest in its operations it assumes at least one or two streams of fixed costs. The portion of the typical monthly payment that covers whatever percentage of the building purchase price was borrowed becomes a fixed cost. The interest owed over the life of the loan also is a fixed cost. The portion of each monthly installment that repays the cost of borrowing declines to some degree each month, while the amount of equity in the building grows. Still, the overall monthly payment usually remains unchanged.
- Depreciation. When one purchases a fixed asset, it enters the accounting records at the amount paid — and almost immediately the accountants set about scheduling a monthly loss of overall value. This is called depreciation, which is a non-cash expense, meaning that it is a “book entry” that regularly reduces the value of the asset until the value of the asset either steadily disappears in monthly steps or remains very low once the “useful life” of the asset has been exceeded.
- Depreciation has the effect of “protecting” cash, but is has the disadvantage of declining slightly each month until either the asset is considered worthless or it has reached what is conventionally known as the “salvage value.” This is one fixed cost that declines every month, so the “cost” is not technically fixed, but close to it.
- Licensing and Re-accreditation. When licenses and/or re-accreditation are part of your program model, these periodic costs become part of your fixed budget. Unless one chooses to somehow spread the cost of these items over a period of years, these often, inescapable, costs are true fixed costs.
- Certain Consultants. Non-payroll specialists such as consultants can be fixed costs. These individuals don’t show up on the payroll because it is often in both parties’ interests to make their time-limited engagement with the organization into a contract relationship. These are the kind of professionals who would be brought in for very specific roles, then separate from the organization once the identified task is complete.
- Insurance (property and liability). Insurance is an inescapable aspect of business today that amounts to a fixed cost — even though in some cases it may feel like a variable cost if the premium is spread over several months. Liability insurance, property insurance, and other similar costs are generally expected to require one-time-only payments.
Fixed costs — commitments an organization takes on that are not influenced by the volume of services — are unavoidable. Seasoned managers know what they are and they try hard not to take on any more fixed costs than they absolutely have to accept. One might be able to spread out the impact on the budget a bit, but as the name implies, the costs won’t go away. Wagner needed those 123 instruments.
Thomas A. McLaughlin is the founder of the nonprofit-oriented consulting firm McLaughlin & Associates and a faculty member at the Heller School for Social Policy and Management at Brandeis University. He is the author of “Streetsmart Financial Basics for Nonprofit Managers,” published by Wiley. His email address is firstname.lastname@example.org