Thinking about income generation and profit in a non-profit world

By Marcus Coetzee, 13 July 2017.

Non-profit organizations and social enterprises that wish to design sustainability strategies need to have clarity around the concepts of income generation and profit, and how to achieve them.

This article aims to debunk some misconceptions around income generation, equity investments, loan finance, and the profits or surpluses that these organizations may generate or receive.

In previous articles, I have focused on legal structures, business models and common confusions. In this article, I propose that non-profit organizations and social enterprises can change the way they cost proposals and transact with their customers (i.e. the people and organizations they are getting money from). I believe this will increase the opportunity to generate income and the profit or surplus that may result. It is hoped this article will help you to better harness your organization’s potential while still delivering on its social goals.

The first issue is the myth that “income generation” and “donations” are separate and utterly different. Non-profit organizations are skilled at fundraising and know how to submit proposals to donors. This is their comfort zone. In contrast, “income generation” is seen as something different, new, “business-like” and sometimes “dirty” – something that should be separated into another legal entity.

This split thinking discourages organizations from exploring easy opportunities to earn income. For example, a national rehabilitation organization recently introduced a differential pricing strategy where certain services are free for poorer beneficiaries but charged to others who could afford the services. This opportunity was in its reach and did not require the establishment of side businesses, additional legal entities etc.

Another recent example is a non-profit organization in the Cape Town townships that wanted to use its extra land to establish various businesses. However, when we explored these opportunities, none turned out to be viable. Instead the organization decided to make better use of its reputation and buildings, and become a “social services hub”. This meant upgrading the value they provided to tenants and bringing in new tenants at more profitable rates. Ultimately, this decision aligned better with the organization’s core values. It also promises to generate a surplus and expand the organization’s social impact.

The second issue is the confusion between “income generated” and “equity investment” or “loan finance”. Income generated is money that is earned or raised and therefore is recorded in the income statement. This income includes many forms such as donations, grants, dividends and the sale of goods or services. “Active income” is income an organization needs to invest effort to earn, whereas “passive income” is money that an organization receives with minimal effort, such as through rental income, dividends or interest.

In contrast, capital investment or “loan finance” is not income, but is equity or liabilities respectively which must be recorded as such in the statement of financial position (former balance sheet). Loan finance must be recorded as a liability as it is money that is owed by the organization. Equity investments occur when someone seeks to earn a return on their investment and usually involves buying shares of a private company (that you or your organization may own) with the hope of future income (dividends) from the investment and/or capital growth.

Remember loan finance can never be treated as income, as the amounts ultimately will need to be paid back. Poor understanding of loan finance often results in organizations being unable to pay back creditors and quickly becoming insolvent. Income from receiving equity investment should not be used to cover day-to-day expenses, but should rather go into reserves, be used to purchase assets (e.g. property for your office), or be used strategically to build/expand stream of income.

It is important for an organization to be clear on what it is aiming to achieve and to pursue appropriate sources of funding. It may not be appropriate to pursue equity investment or loan finance when the organization should be focusing its efforts on generating the income it needs to cover its on-going costs.

The third issue relates to earning a “profit” or “surplus”, which arises when income earned from activities is greater than the true and full cost of these activities. These surpluses or profits can help organizations to build reserves, fund strategic activities, expand operations and manage risk. However, some leaders are uncomfortable with non-profit organizations earning a profit. Surprisingly, some donors, businesses and government departments also expect non-profit organizations to work at discounted rates without any surplus being generated.

I believe that it depends on how the profit was generated and how it is applied. It is essential that beneficiaries are not undermined, neglected or misused in the process, and that profits and surpluses are reinvested so that they can further the mission of the organization.

The term “non-profit” means that no profits should be distributed in any form to investors, donors, staff or board members in the form of hefty salaries or bonuses, or other stakeholders.

It is vitally important that non-profit organizations cost projects fully in order to match the costs to the income stream. Organizations could, at times think that they’re making a profit from their income-generating activities, but they may not be. If the income does not cover the full costs of implementation, including a share of the overheads, it would result in them cross subsidizing these initiatives through other income sources.

Organizations that do this are far more likely to run into cash flow problems as they may use their reserves, other income sources or advance payments to fund current activities. They may also choose to reduce their overheads to accommodate their donors, but this may have negative consequences for their ability to deliver and for their futures. For example, it may leave them unable to pay market-related salaries to their staff.

Rooted within this constraint is a narrow set of budgeting skills. Non-profit organizations tend to present donors with a budget that represents a vertical slice of their income statements – a portion of all their actual costs, including overheads and direct project costs. Too often this is followed by arguments with their donors about what proportion of overhead or administration costs are moral or appropriate. Some donors will want to pick and choose which costs they fund, which is normally the “attractive” direct costs. These donors may preach sustainability, but just not in the projects they fund.

However, there are three other costing methods that could potentially enable a non-profit organization to earn a “profit” (or at the very least cover all costs). These include:

  1. unit costing (for example, the cost per workshop);
  2. outcomes-based funding (for example, the cost per child successfully rehabilitated)
  3. charge-out rate or consultancy costing (for example, charging a facilitation fee for a training course)

Organizations such as CMDS and Dalmeny Consulting can teach such costing methods.

The fourth issue is the lack of clarity about the difference between forms of income (e.g. donations) with sources of income (e.g. CSI departments). For example, an organization may say that they want to get sponsorship from a business and refer to this as “donations”, but then the business will expect (and can’t be issued with) a section-18A certificate. However, a request for sponsorship should be a transaction with the marketing department of a business and should be invoiced for and not treated as a donation. In this example, the business should not ask for or need a section-18A certificate or any proof of the non-profit legal form of the organization, as the expense is deductible as a marketing expense.

Since good strategy requires clear thinking and precise terminology, it is worth listing potential sources and forms of income. This will assist organizations to think broadly about the full range of options at their disposal, and help them to match form of income with source of income.

“Sources of income” really represent the “customers” of the non-profit organization or social enterprise – the place where the money is coming from. They include foundations, businesses (corporate social investment or CSI departments, enterprise development departments, procurement departments, marketing departments), government, beneficiaries, other non-profit organizations, individuals, universities, international institutions etc.

“Forms of income” refer to the nature of the contractual relationships with the customer (or source of income) and relate to how the income is being generated. These include donations, grants, dividends, subsidies, bequests, profit shares, sale of goods (e.g. wheelchairs, educational toys, consumables) or services (e.g. rentals, technical support, consulting, project management, fund management, training fees, cause-related marketing, sponsorships, brokerage) etc.

Once an organization is clear about what they are asking for or selling (the form of income), then it will need to use the appropriate language and deal with the correct people.

The fifth issue is the distraction posed by legal forms. It is tempting for organizations seeking to generate income and earn a profit to begin by engaging in vigorous debates about legal forms, hybrid social enterprise models etc. Too easily, this becomes a distraction. Rather, this conversation should happen only once markets and business models have been finalized and tested, as this process will reveal the best legal forms for the situation.

The danger is that organizations which do not “road test” new strategies may end up creating complex bureaucratic arrangements, frequently unnecessarily. They may also be distracted from more important issues such as how to serve their beneficiaries and generate the income and profits they need.

In conclusion, donations are merely one form of income. Profits (or surpluses) are desirable, provided beneficiaries are not neglected and any profits are reinvested in the organization.

I believe that non-profit organizations are likely to be surrounded by more opportunities to generate income and make profits than they think. However, this will only become apparent once they stop thinking of income generation as something different from grants and donations, and once they start looking for opportunities within their existing sphere of influence, rather than outside. Focusing first on what is within reach will also help mitigate mission drift.

Ultimately, income and profit emerges from how an organization transacts with its customers. This approach will require organizations to learn new skills, practice new habits and adopt a different mindset. Although embarking on this process may feel intimidating at first, the benefits of being in a stronger strategic and financial position should make it worthwhile.

This has been a complex and controversial topic to tackle. This article would not have been possible without the valuable input by Cathy Masters (CMDS), Fanie Nothnagel (Dalmeny Consulting), Andy Simpson (Imani Development) and Nicole Copley (NGO Law).

In pursuit of strategic clarity

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