What does it mean to be a nonprofit organization?
Although it may seem like a basic question, understanding what it means to be a nonprofit organization is the foundation of being able to understand a nonprofit’s financial reporting and management.
The most basic characteristics of nonprofit organizations are that:
- They do not operate with a profit motive (i.e., nonprofits do not exist solely to create a profit), and their activities generally relate to religious, charitable, scientific or educational purposes;
- They have unique performance metrics and KPIs;
- They hold a tax-exempt status; and
- They often face challenges with their governance, personnel and management structures.
And while these characteristics offer a basic understanding of what it means to be a nonprofit, the best way to fully grasp what it means to be a nonprofit is to examine how these characteristics are different from those of a for-profit organization.
Difference Between a Nonprofit and For-Profit Organization
Nonprofits have a different motive, different sets of performance metrics and different levels of flexibility than a for-profit organization. In addition, nonprofits have unique governance and personnel challenges. These four areas are key to understanding the difference between a nonprofit and for-profit company, and thereby what it truly means to be a nonprofit.
1. The Organization’s Motive
While for-profit companies exist for the purpose of—you guessed it—making a profit, nonprofit organizations exist to maintain assets in order to continue providing and expanding services that support their mission.
A common misconception is that operating without a profit motive means not being allowed to have a profit. This is far from the truth!
When nonprofits are able to have a surplus of revenues over expenses—a “profit”—the surplus can be re-invested into the organization. This allows the organization to continue to expand its services. Therefore, the better managed a nonprofit’s finances are, the more money is left at the end of the day to grow and expand the mission.
2. Performance Metrics and KPIs
Nonprofits have different performance metrics and key performance indicators (KPIs) than for-profit companies.
For-profit companies typically rely on profitability, or the bottom line, to measure overall performance. But because nonprofits are not profit-driven, profitability is seldom used to measure how a nonprofit is performing. Instead, nonprofits rely on program outcomes to measure performance.
Each nonprofit has its own unique measurement standards. For example, a food bank may measure performance based on the number of meals served, whereas a crisis and counseling center may measure performance based on the number of counseling sessions provided.
Further, depending on the number of programs that a nonprofit has, there could be different performance metrics for each program. Determining which performance measurement standards your nonprofit should apply is key to understanding your organization’s overall effectiveness, as well as what information is needed for accurate financial reporting.
3. Tax Status and Overall Flexibility
Because of their tax status, nonprofits don’t have the same flexibility as their for-profit counterparts with regards to expansion—a key difference between nonprofit and for-profit organizations.
Once a nonprofit establishes its tax-exempt purpose with the Internal Revenue Service (IRS), it must be careful to operate within the bounds of that purpose. If a nonprofit strays too far from its original tax-exempt purpose, it risks paying taxes (unrelated business income tax) on income from those activities. Or—worst case scenario—its tax-exempt status could be revoked.
In addition to being concerned about the IRS, nonprofits must also be mindful of funder requirements. Many nonprofits receive a substantial portion of their revenues from grants and contributions. Often, these grants and contributions come with specific restrictions for that funding or performance requirements. Not meeting these requirements can result in the loss of funding.
Further, if the award conditions cannot be satisfied without jeopardizing a nonprofit’s current mission, otherwise known as “mission creep,” serious consideration should be given as to whether to accept the award. Therefore, to avoid loss in funding and to avoid mission creep, it’s imperative to understand all the requirements of an award before making the decision to accept the award.
Straying away from the tax-exempt purpose, or not following funding requirements, can have serious negative impacts on a nonprofit organization.
4. Governance, Personnel and Management
Finally, nonprofits face different challenges than for-profit enterprises when it comes to governance, personnel and management.
Nonprofits are generally governed by an independent Board of Directors. Often nonprofit Board members are volunteers who serve for limited terms, so it is more difficult to maintain continuity and depth of knowledge at the Board level.
In private for-profit enterprises, the Board of Directors may include owners, related parties and members of management who are not independent. In addition, there are often no term limits for Board members of private for-profit enterprises. This makes it easier for for-profit companies to build Board consensus, which allows for a quicker decision-making process.
In addition to differences in Board composition, there is also a significant difference between nonprofit and for-profit enterprises when it comes to personnel. Nonprofit organizations are often dealing with funding limitations on compensation. This can result in employee dissatisfaction and higher levels of turnover. To compensate for these funding limitations, nonprofits often rely on volunteers to help carry out the organization’s mission.
Although there is turnover in any organization, for-profit enterprises generally don’t have the same funding limits that nonprofit organizations have. Therefore, for-profit enterprises have greater flexibility when it comes to compensation packages.
Understanding What It Means to Be a Nonprofit
As you can see, there is a significant difference between nonprofit and for-profit organizations. Understanding these differences lays the foundation for understanding financial management and reporting within a nonprofit organization.
For more information about nonprofits or to learn more about how your nonprofit can better understand its financial management and reporting, reach out to your Warren Averett advisor, or ask a member of our team to reach out to you to get the conversation started.