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This is the first of five articles that will cover business model considerations of five major revenue sources: earned income, government, foundation, individual donor, and membership funded. It was produced as a part of the Nonprofit Financial Commons Course, The Five Nonprofit Business Models Revealed. We are indebted to Hilda Polanco, John Summers, and Ruth McCambridge for their thoughtful observations and contributions to this piece. This unique series is designed to discuss business model considerations including required infrastructure, inherent risks, and capitalization needs. The whole collection accompanies a series of seminars also available on this site.
It’s Not A Side Gig
Of all the sources of revenue supporting nonprofit activity, private fees for service constitute the largest percentage by far at more than a trillion dollars1 annually, or half of all revenue coming into the sector. The bulk of this type of revenue, however, flows to larger nonprofits like hospitals and universities, whereas this article is written for small and midsize nonprofits that may or may not have earned income (which includes money earned from some government and other contracts) as a significant part of their current revenue mix. Those that already have a strong earned income component likely recognize it as a traditional source of revenue for their field as a whole, because among nonprofits, there are generally revenue types dominating each field.
But whether your organization already incorporates an earned income revenue stream or is considering adding one, you will want to keep in mind several strategic and operational considerations relevant to selling goods or services directly to your market rather than to a third-party payer (like the government or a foundation).
A Myth and A Trap to Avoid
The “myth” is the longstanding prescription that nonprofits should always be working toward a revenue base that’s broadly diversified. This isn’t about earned income specifically; the reason we bring it up is that many nonprofits at least entertain the possibility of an earned income project in their bid to create revenue diversity. Indeed, the idea of a diversified revenue base sounds right—we imagine that it is a necessary factor for growth, or justify it as bringing an equilibrium that can help withstand disruptions to one or more of our regular revenue streams. Neither notion proves out in practice2 without being attached to far more specific strategic intentions. Beyond that general caution, remember that many for-profit businesses fail within their first ten years, some without having ever turned a profit. Think deficit.
The “trap” is specific to earned income: Many nonprofits cling to the hope that an uncomplicated cash cow business could be attached to their organization in a way that fills those pesky annual budget gaps with unrestricted money. This is an achingly familiar vision that often does not pan out financially and can be costly to your parent nonprofit in more ways than you ever imagined.
The First Consideration
Ask yourself this question: Is there an earned income-producing activity that is a particularly good and natural fit for our nonprofit’s mission? This question appears to be a core driver to success or failure in earned income projects, so it is a good place to start. Recent research indicates that there are at least two major factors here: how core the activity you are considering is core to mission achievement, “embeddedness,” and the overlap in what some refer to as “organizational technology”3 but we will call organizational infrastructure.
THE EMBEDDEDNESS TEST
Embeddedness the refers to the degree to which an earned income activity is central to mission accomplishment in ways other than simple income generation—in other words, how related it is to the nonprofit’s core purpose. An example of this might be Goodwill Industries. Substantial research on this issue indicates that an earned income venture that’s more embedded produces not only better revenue results, but better program outcomes.4 And this makes good sense: Establishing a business requires levels of intense focus, sweat equity, and capital beyond what we can anticipate. An unrelated business endeavor runs the risk of actually detracting from mission, and in the worst case, it can sink not just the revenue production scheme and related costs, but the parent organization itself. When this occurs, it’s often because the nonprofit saw the earned income activity primarily as a revenue generator—a “cash cow.” The likelihood of failure for any business startup is high, and running up costs unrelated to accomplishment of mission is a high-risk endeavor for an organization with ambitious mission goals and tight margins.
Embeddedness must also be considered when it comes to taxation. Many nonprofit leaders are aware of the federal Unrelated Business Income Tax (UBIT) on organizations whose business ventures stray too far from their mission, but recent years have also brought challenges to organizations’ property tax exemptions. Many of these challenges have been levied against larger “eds and meds,” but they have also surfaced elsewhere, as in the case of a Nebraska-based Goodwill organization.5
By the way, part of the reasoning behind UBIT was the potential for nonprofits to undercut for-profit business by virtue of reduced taxation and other subsidies. This can complicate development if for-profit providers in the field challenge a nonprofit on “restraint of trade” principles.
ORGANIZATIONAL INFRASTRUCTURE FIT
Organizational infrastructure can encompass managerial expertise and “core competence,” technological systems, and even networks and markets.6 These components of an organizational system are foundational building blocks that allow for effective innovation, and the degree to which these capacities overlap between parent nonprofit and income-producing endeavor is helpful to maintaining focus, alignment and synergy.
ReStores: An Illustration of One Mission-Infrastructure Match
“[T]he nonprofit Habitat for Humanity International strives to tackle the global housing crisis through building and rehabilitating housing for families in need around the world. One of the organizations primary fundraising sources is the Habitat for Humanity ReStores. With 825 stores across the United States and Canada Habitat accepts donations of new and used home appliances and construction materials from consumers and corporations, selling the goods at discounted prices and applying the proceeds to its charitable construction projects (Habitat for Humanity 2012). In order to support its social enterprise function non-profit ReStores partner with for-profit home improvement giants in the building industry including Home Depot, Lowe’s, and 380 A. W. Montgomery et al. 123 Rona. While Habitat is able to fund its primary activity of building homes through such alliances the corporations likewise receive numerous benefits. These include environmentally responsible ‘disposal’ services for unneeded product which would otherwise go to landfill, tax exemptions for in-kind charitable donations, and reputational benefits and publicity for participating in Habitat’s housing mission (Habitat for Humanity 2012).”7
What Does an Earned Income Enterprise Take in Practical Terms?
The important work of gauging the market
Nonprofit business endeavors, like for-profits, must understand the market in which they operate. Who can be seen as competitors or partners (as with supply chains)? What cultural notes should be considered? What models of fee-for-service provision exist elsewhere that might transfer well to your effort? What special conditions exist if your market is rural that would not be present in an urban or suburban setting? What regulations do you need to observe, and will there be costs associated with them? These questions and many more must be considered to meet the market efficiently, effectively, and with the right impact.
The pricing of services is contingent on a variety of factors, some of which involve comparable costs and quality (i.e., what the market can bear). This is a marketing function, true, but it is also a function of accurate projection of costs—and, yes, values and quality proposition choices. For this last set, consider the fields of nursing homes and hospices.8
Identifying and monitoring full costs in an expanded way
When considering any revenue-generating activity, it is crucial for nonprofit leaders to consider the full costs of the activity, including taxes, equipment and materials, and staff time, which includes but is not limited to administration and marketing. For example, if you’re selling branded clothing, that can require design and production, storage space, shipping costs, staff time to manage inventory and sales, and accounting processes to accommodate those transactions. Providing space rental means using staff time to negotiate contracts and to envision and structure the endeavor with the market—not to mention potential increases in liabilities and the costs of utilities and insurance. Further, while nonprofits are allowed to use volunteers in most areas of their mission-related work, commercial businesses that serve the public (like a gift shop or thrift store) may be subject to the Fair Labor Standards Act (FLSA) and require that certain activities be performed by paid staff.
Creating a business plan
Business planning is a disciplined activity that lets you recognize lapses in your internal logic or gaps between your expectations and the market’s realities. The scenarios you produce project both expenses and income, and the space between the two will offer a sense of your capitalization needs.
A business plan is a working document
Some of the assumptions in a business plan may be in alpha-test or hypothetical form. The plan should be treated as a “living document” and revisited often as markets change. A good business plan should result in a dashboard that allows the board and staff to measure efforts according to agreed-upon goals and standards and with a shared understanding of when and how to take action to limit potential losses.
Where to find benchmarks
“Industry” benchmarks can be invaluable if accompanied by the proper contextual considerations. This kind of information can, in the best of cases, be found in research issued by intermediaries such as the Institute for Nonprofit News or Habitat for Humanity.
In the arts, for instance, the average percentages of revenue type (according to a recent study by Americans for the Arts) are:
- 60% earned,
- 30% contributed, and
- 10% government sourced.
But within that “standard” one finds many variations that stem from size, geography, capitalization, and identity/niche choices. Drilling down into what a choice like the provenance of art presented, or the possibility of facilities ownership, might mean for your finances is part of developing a business plan that is best suited to mission.
See our business model grid for a quick look at the risks and requirements of earned income.
When Government Subsidies for Service Are a Must
Many earned income endeavors are paired with other types of revenue streams, but in direct care models that depend upon government entitlements/benefits, a co-pay of sorts may be required to make a service accessible and affordable to the population being served. This complicates the model with money that is indeed earned but in large part involves payment from a third party like Medicaid. This model adds administrative cost and complexity to every transaction.
Organizational Infrastructure Considerations for Earned Income
Leadership and Staffing
First and foremost, an organization that brings in earned revenue will need to ensure compliance with all IRS rules, which may call upon finance staff to enhance their expertise in this area. As noted above, nonprofit leaders must pay attention to the Unrelated Business Income Tax rules of the IRS—put simply, nonprofits may be responsible for taxes on revenue that derives from activities insufficiently related to their mission. The team will then need a thorough understanding of the business model of its revenue-generating activities and how their budgeting, monitoring, and operations may differ from other nonprofit practices. For all intents and purposes, these activities represent their own small (or large) businesses and require management and accounting expertise specific to that business. The finance staff will need individuals with strong data entry skills at the transactional level to manage billing and accounts receivable for the earned revenue stream.
Additional Staff Roles
Earned revenue requires additional leadership across finance and program, and often staff with specific authority over the revenue.
|Roles and Responsibilities
|Executive Director (ED)
|The ED leads the decision-making process around pursuing earned revenue, with an eye toward the potential revenue benefits and risks to the organization as well as fitness between earned revenue strategies and organizational mission.
|Development Director (DD)
|The DD may be charged with soliciting capital to support earned revenue endeavors, particularly in the startup phase. The DD will also need to have a clear picture of how this revenue stream fits with the overall business model, budget, and needs of the organization so that they can pursue contributed revenue at appropriate levels.
|Program Director (PD) or Manager
|Should a program director be in charge of revenue-generating activities, this individual will need budget oversight, planning ability, and a vision for how to create/expand the potential of a revenue source. The PD may need to make investments in infrastructure or supplies, work with marketing staff to attract the attention of consumers, and work closely with finance on accounting matters.
|Board of Directors
|The Board of Directors may be called upon to approve a nonprofit’s forays into earned revenue and will likely have influence on how this activity is presented/developed at a strategic level to protect the nonprofit’s reputation and core service areas.
|Other Roles: Rentals Manager, Artistic Director, Designer, External Relations & Marketing / Communications, Director of Licensing, Box Office
|Depending upon the specific revenue model, the nonprofit may need additional staff who are responsible for managing that area of the business. For instance, a nonprofit that rents part of its property for weddings and galas might employ someone to manage that aspect. An organization that grows and sells produce through a CSA will need staff to pack and distribute food boxes. A nonprofit that wants to sell branded merchandise may need to hire someone to manage production of those items. Sales endeavors often require the support of marketing/communications staff, and licensing may require professionals in that area as well.
Accounting and Software Considerations
Nonprofits can manage their earned revenue in the same accounting software systems they use for other forms of revenue, with a few caveats. Unlike contributed revenue, finance should recognize earned revenue only upon delivery of the item or service to the customer (known as an “exchange transaction”). For example, if a customer (e.g., a local corporation) contracts with a nonprofit on a year-long project (say, providing volunteerism training and opportunities to corporate staff), the nonprofit cannot recognize all the contract revenue at once, but only as services are delivered over the life of the contract. Finance leaders should make sure to update and distribute policies and procedures that reflect these differences in revenue recognition. Note that some arrangements may require judgment and expertise as to whether a transaction is a “contribution” or an “exchange” (think memberships, subscriptions, sponsorships, conferences—even some federal and state grants and contracts). And some transactions that include both contributed and earned revenue components may need to be bifurcated for revenue recognition purposes.11
With policies and procedures in place, the finance team can track earned revenue as they would any other program in the accounting system by attributing them to an activity or cost center. And just as nonprofits benefit from an understanding of the true costs of their programs, they should look at the true cost of any earned revenue activity to understand pricing and net profits. In for-profit accounting, we more frequently see the concept of Cost of Goods Sold (COGS), which is the direct cost of an item sold. For nonprofits, this accounting structure may only be necessary if producing goods for sale. No matter the budget structure, leadership should keep a careful eye on true costs and net revenue when evaluating an earned revenue program, and thus finance should set up the accounting system to enable thorough monitoring.
If the revenue stream ends up being liable for UBIT, the finance team will need to be prepared to fully allocate costs in order to track activities on a separate P&L for their 990T tax return.
Other Software Systems
Unless an organization is pursuing a particularly complex earned revenue model, the finance team should be able to maintain its current accounting software systems so long as there are plans and processes for importing sales information into the accounting software. Some things to note:
- If asking for donations alongside purchases, such as donations on top of ticket sales, ensure proper accounting for and separation of the two elements. Track the earned revenue activity independently, as shown above.
- Most electronic sales platforms impose fees that must be accounted for.
- Establish procedures to reconcile cash deposits against daily sales, if applicable.
- When using point-of-sale, ticketing, or billing systems, ensure proper reconciliation with accounting and prioritize systems that can sync with the accounting software for increased efficiency. Some of the more robust accounting systems may have modules or add-ons to accommodate such activities.
There are many success and failure stories in the arena of nonprofit earned income, which also can be seen as collective entrepreneurism. For organizations in fields where such revenue streams are common, you may easily find a wealth of case studies, tools, and other information to help you build and, over time, fine-tune your models as conditions and approaches progress. But nonprofits innovate by nature, and that leads to the constant emergence of new models to wonder over. Don’t be afraid to ask your colleagues who are steering those efforts to share the knowledge and experience they have gained experimenting with new markets, forms, and transaction models. We at the Nonprofit Financial Commons stand ready to help.
- Pratt, John, and Aanestad, Kari. “NPQ’s Illustrated Nonprofit Economy, 3rd Edition” [Infographic].
- Lu, Jiahuan & Lin, Weiwei & Wang, Qiushi. (2018). “Does a More Diversified Revenue Structure Lead to Greater Financial Capacity and Less Vulnerability in Nonprofit Organizations? A Bibliometric and Meta-Analysis.” (2019). VOLUNTAS: International Journal of Voluntary and Nonprofit Organizations. 30. 10.1007/s11266-019-00093-9.
- Levine Daniel, J., & Kim, M. “The scale of mission-embeddedness as a nonprofit revenue classification tool: Different earned revenue types, different performance effects.” Administration & Society, 50(7), 947-972. https://doi.org/10.1177/0095399716647152
- McCambridge, Ruth. “Goodwill Omaha’s ‘Bad Business’ Model May Affect Property Tax Exemptions of Other Local Nonprofits.” Nonprofit Quarterly. October 26, 2016.
- Prahalad, C.K., and Hamel, Gary. “The Core Competence of the Corporation.” Harvard Business Review. May–June 1990.
- Montgomery, A., Dacin, Peter, & Dacin, Tina. (2012). “Collective Social Entrepreneurship: Collaboratively Shaping Social Good.” Journal of Business Ethics. 111. 10.1007/s10551-012-1501-5.
- Gray, Nathan. “Op-Comic: The perils of a profit motive in hospice care.” Los Angeles Times. February 23, 2023.
- “Social Enterprise Business Plan.” Propel Nonprofits.
- Polanco, Hilda H., and the Editors. “Models and Components of a Great Nonprofit Dashboard.” Nonprofit Quarterly. March 30, 2016.
- The relevant accounting guidance is from FASB ASC606: see here for more details and documentation.