Operating Reserve Policies are a Perfect Vehicle for Targeting Your Budget’s Bottom-Line
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Nonprofit organizations would greatly benefit from adopting a standardized policy for strategically targeting and managing their annual budget bottom-line. You could argue that there is no greater safety net for overall financial health than having a formal policy, or at least a budget working rule or guideline, for this important metric.
Most nonprofits have detailed budget preparation processes that are also coupled with legacy budget thresholds for key budget line-items. A legacy budget threshold is often based on informal gut feelings and/or historical beliefs that for certain high visibility budget areas, informal precedence and practices are applied. This results in relying on old, and often outdated, assumptions like “we always budget in this range” or “this will look good to the Board” instead of relying on an operational policy.
There will always be some legacy budget practices that are naturally driven by past experiences such as the budget bottom-line. However, you will see improvements in clarity, financial health, and performance when you convert a legacy budget practice to a formal policy.
My preferred strategy for formalizing a budget bottom-line target is to use an operating reserve policy that establishes a threshold range. This is an advantageous governance and management practice for several reasons.
First, I like budget related actions, when appropriate, that reside outside the budget process. This provides an opportunity to explain and expand the “why” behind the policy and pushes oversight outside of just the finance committee.
Second, it establishes that financial fiduciary responsibilities are shared throughout the organization’s governance and management systems and practices. This will enhance sustainability and continuity and creates a better visual regarding the organization’s commitment to transparency and accountability.
A thoughtfully drafted operating reserve policy will complement your budget guidelines and practices and fulfill the role of formalizing a budget bottom-line threshold. I recommend structuring the operating reserve policy in four sections that addresses the different ways of communicating operating reserve goals, the linkage to the budget bottom-line targets, and annual status reports. Thus, the four operating policy sections I recommend are as follows:
Section #1 – Operating Reserve Goals Defined in Terms of “Mission”
Section #2 – Operating Reserve Goals Defined in Terms of “Percent of Budget”
Section #3 – Budget Bottom-Line Actions Based on Current Operating Reserve Goal Status
Section #4 – Annual Operating Reserve Goal Status Reporting
Section #1 – Operating Reserve Goals Defined in Terms of “Mission”
Operating reserve policies that connect to the organization’s mission and programs portray a powerful message of organizational strength and commitment to long-term sustainability and continuity. This is why Section #1 is so important.
Communicating the organization’s operating reserve goals in terms of its mission and programs is more meaningful than stating an operating reserve goal with no context. For example, you might explain that a particular level of operating reserves would cover 150 recipients for 6 months of continuing support services, one year of membership services, 6 months of bridge grant funding, one year of research and development funding support, one year of staffing support, etc. This is a far more powerful and illustrative message than merely stating an operating reserve goal of, for example, $3 million, with no other context.
Section #2 – Operating Reserve Goals Defined in Terms of “Percent of Budget”
In Section #2 we convert the “mission-based” operating reserve goal to a simple budget formula based on either percentage of the total annual budget (e.g., 50% of annual budget) or number of months of the total annual budget (e.g., 6 months of annual budget). This formula is easy to remember and use for tracking the organization’s operating reserve status and reporting on performance goals.
An additional benefit of Section #2 is that outward facing communications relating to operating reserves will be clear and concise and not detract from current fundraising and grant development efforts. For example, outward facing messaging could be crafted as follows:
Our operating reserve goal is to have liquid funding to support one year of membership services, which equates to an overall operating reserve goal of 6 months of our annual budget.
Our operating reserve goal is to have supplemental funding in-place to support 24 months of medical research and 12 months of awards and scholarships, which equates to an overall operating reserve goal of 9 months of our annual budget.
There is no uniform set of guidance on operating reserve policies and the specific threshold goal for operating reserves. The specifics vary depending on the type of organization and its specific circumstances. However, I follow two rules when it comes to setting operating reserve goals:
Rule #1 – Use a standard measurement scale of “Number of Months” of your current annual budget.
Rule #2 – Have a Financial Health Measurement scale to frame your operating reserve goal threshold target:
Red Zone (Weak Financial Position): Less Than 3 Months of Operating Reserves
Yellow Zone (Starting to Establish a Healthy Financial Position): 3 to 6 Months of Operating Reserves
Green Zone (Stronger Financial Position): 6 to 12 Months of Operating Reserves (more can sometimes be appropriate for organizations that have extended operating cycles resulting from bi-annual and tri-annual major programs such as certification, testing or meetings that do not occur every year which reside alongside annual programs and operations)
Recognize when setting your operating reserve goal target that 6 to 12 months of operating reserves is the common benchmark range for many nonprofit organizations. When establishing your first goal or when updating your operating reserve policy, I recommend leaning towards the lower end of the scale (6 months) if you have little operating reserves built up, and leaning towards the higher end of the scale (9 or 12 months) if you already have a lot of operating reserves built up. I like an operating reserve goal that is on the higher side and slightly out of reach so the temptation to use over funded operating reserves is reduced.
Section #3 – Budget Bottom-Line Actions Based on Current Operating Reserve Goal Status
The linkage to the budget bottom-line target threshold resides here in Section #3. Based on your operating reserve goal target established in Section #2, list in a table format your annual budget bottom-line threshold targets as follows based on your current operating reserve goal status:
Below Operating Reserve Goal (Annual Budget Target Range): 3% to 5% Surplus
Near or At Operating Reserve Goal (Annual Budget Target Range): 2% to 3% Surplus
Above Operating Reserve Goal (Annual Budget Target): 1% to 2% Surplus
These bottom-line ranges need to be right sized to your organization. There is no standard range. However, note that budgeting for a surplus of greater than 5% (means you would be saving more than a nickel of every dollar collected) is often not obtainable, so I set the top-end at 5%. My bottom-end threshold is 1% because I do not like deficit budgets. If the organization’s management and Board choose to go with a deficit budget in a particular year, the action should be based on special documented circumstances and with a separate recognized Board approval action.
I am generally not worried about how long an organization will take to reach its operating reserve goal. What Section #3 accomplishes is the establishment of a policy and a culture of adding to operating reserves on a steady long-term basis. This is an important aspect of enhancing sustainability. Visualization and reporting on this goal shows up in Section #4.
Section #4 – Annual Operating Reserve Goal Status Reporting
This section provides for the preparation of an annual Operating Reserve Status Report to be delivered to the finance committee and the Board of Directors. This report is prepared using final year-end audited financial results with inclusion of a projection based on the next year’s Board approved budget. Include in the status report your actual operating reserves for the year just completed and the two previous years as well as a projection of the impact from the next fiscal year budget. Also make sure to include a computation for each year in terms of the number of months of budget that is contained in your operating reserves. The budget benchmark for the number of months is based on the most current year Board approved budget.
Planning Tip – If your organization has the good fortune of accumulating significant operating reserves, consider adding a 5th section to your operating reserve policy to define both emergency and non-emergency permitted use of operating reserves. This would include percentage use allowances and how to gain Board approval. Consider the approach of “metering-out” operating reserves that we discussed in this previous article.
Conclusion
Having a comprehensive operating reserve policy is a significant pillar of long-term fiscal and financial sustainability. One of the best benefits of an operating reserve policy will be turning an informal legacy budget action into a set budget practice that will help your organization for many years. Future Board members and management will thank you for taking this positive policy step forward.
