Operating Reserve Policies are a Perfect Vehicle for Targeting Your Budget’s Bottom-Line

This piece is Part 1 of 4 in our Nonprofit Operating Reserves Series.

Nonprofit organizations will greatly benefit from adopting a policy for strategically targeting and managing their annual budget bottom-line. There is arguably no greater safety net for overall financial health than having a formal, Board-approved policy that links budgeting goals and objectives with building and maintaining adequate operating reserves.

Most nonprofits have outdated budget preparation processes that are coupled with legacy budget thresholds for key budget line-items.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 amounts, informal precedents and practices are applied. This results in relying on old, and often stale, assumptions like “we have always budgeted in this range” or “this will look good to the Board” instead of relying on a strategic objective or an operational policy.

There will always be some legacy budget practices that are naturally driven by past experiences. However, you will see improvements in clarity, financial health, and performance when you convert a subjective informal legacy budget practice to a formal policy. 

My preferred strategy for formalizing a budget bottom-line target policy is to use an operating reserve policy that establishes a minimum-maximum range. This is an advantageous governance and operational practice for several reasons.

First, this practice establishes budget compliance requirements that reside outside the budget process. This is preferable because it provides an opportunity to explain and expand on the “why” behind the policy and pushes oversight to the full Board rather than just the finance committee

Second, having an operating reserve policy with a min-max range reinforces the idea that financial fiduciary responsibilities are shared throughout the organization’s governance systems and management practices. This will enhance sustainability and continuity and create a better perception of the organization’s commitment to transparency and accountability.

A thoughtfully drafted operating reserve policy will also complement your budgeting  practices and fulfill the role of formalizing a budget bottom-line target.

I recommend structuring the operating reserve policy in four sections that address the different ways of communicating operating reserve goals, the linkage to the budget bottom-line targets, and annual status reports. The four operating policy sections 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 only in “dollars” 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 guidelines on operating reserve policies and the specific threshold goal for operating reserves, and the specifics can vary depending on the type of organization and its specific circumstances. However, most operating reserve goals are set between 6 and 12 months of the organization’s annual budget. It is best to 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. For example:

• 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)

As a general rule of thumb, lean towards the lower end of the scale (6 months) if your organization has little or no operating reserves built up, and lean towards the higher end of the scale (9 or 12 months) if your organization already has a lot of operating reserves built up. I like an operating reserve goal that is on the higher side and slightly out of reach to encourage organizations to continue to add to operating reserves each year.

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 the operating reserve goal target established in Section #2, list in a table format your organization’s 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), and this is often not attainable, so 5% should usually be the top end of the range. A bottom-end threshold of 1% to 2% is recommended because it encourages an attitude of always adding to operating reserve.

Don’t worry too much about how long your 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 one of the most important aspects of boosting sustainability. Visualizing 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 organization’s actual operating reserves for the year just ended 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 with provisions addressing spending. As discussed in Part 4 of this series, this would include percentage use allowances and how to gain Board approval. Consider the approach of “metering-out” operating reserves that we described in this article.

Conclusion

Having a formal, Board-approved 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 informal arbitrary past budget actions into a set budget practice that will help your organization future planning. Future Board members and management will thank you for taking this positive policy-based step forward.