Strategic Budget Cutting

By David Maddox

Budget cutting has become one of the most common and unpleasant tasks
confronting nonprofit managers. While budget reductions have always been
part of the normal cycles of deficit and surplus, of organizational growth and
demise, "doing more with less" is now seen as a virtue worth pursuing for its
own sake. However questionable that mantra may be, new waves of budget
cutting are likely to hit different segments of the nonprofit sector for the
foreseeable future.

Since most organizations have little in the way of unjustified spending to

eliminate, there are few easy targets. Managers must approach budget
cutting with care, so as not to harm the organization's capacity to achieve its
purposes. The toughest question they face is how to reduce the budget
without compromising the organization's mission.

Reasons for Budget Cuts

As a first step in developing a strategy for cutting budgets, the organization

needs to understand the reasons driving the cuts. Some of the most common
are:

• Cutbacks by funders and governments. Government funders will

reduce funding as revenues decline or policies change. A governmental
budget deficit is likely to result in reduced funding for nonprofit
organizations. At times, funding cuts will be driven more by changes in
policy, such as the cutbacks in appropriations to the National
Endowment for the Arts that were driven by Congressional skepticism
about the government's role in funding arts. Foundations and other
funders may also cut back funding as a consequence of poor stock
market performance or changes in their program focus.
• Lower demand for services and the emergence of new providers. Like
any organization offering services in a market environment, a
nonprofit organization may experience fluctuations or reductions in
demand. Or new providers may emerge who take market share. In the
education marketplace, the demand for admission to degree programs
may decline as the number of high school students declines or as the
economy improves. Nonprofit schools catering to adult students have

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 found new for-profit competitors entering the market, threatening to
take students away from the traditional nonprofit provider.
• Spending not controlled in the face of slower revenue growth. In a
period of slowing revenue, expense growth must be contained to
maintain financial equilibrium. This cause for cutbacks reflects the
organization's failure to respond to changes in revenue and exercise
adequate financial discipline, in contrast to the external factors cited
above.
• Price competition. A nonprofit may find that its prices for services
have gotten out of line. A good example is found in health care, where
some nonprofit providers have been pushed by lower-cost providers to
reduce their prices, forcing them to undergo serious programs of cost
reduction.
• Unusual cost events. In some cases, singular events may occur that
drive up costs independent of the organization's ability to raise more
revenue. One such watershed event was the oil crisis of the 1970s,
which resulted in large increases in energy costs for institutions and
arguably inflated other costs as well. Such events can force
organizations to realign costs and revenues across the board.

Determining the Size of Cuts

Once an organization has concluded that cost reductions are necessary, it

must determine the extent of the cuts. The size of the cuts may be mandated,
in the case of government agencies, or may be determined through some sort
of financial modeling. Such modeling may take a relatively informal form,
such as having the organization's leaders review projections or actual
programs that show a deficit and deciding what portion of the gap they will
make up from revenue increases and cost reductions. In most cases, more
formal financial modeling is advised to take into account timing effects and
the combination effect of different factors.

For example, if positions are held vacant, the effect will build over time as the
vacancies actually occur. An organization with 10 percent turnover will not
experience cost savings of 10 percent in the first year of a freeze. It is more
likely to see savings of around 5 percent if vacancies are evenly distributed
throughout the year. In the second year of the freeze (though hiring freezes
can seldom be maintained that long), the organization would have a
reduction of about 15 percent in salary costs from the baseline year.

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Combining a wage freeze with a hiring freeze might hobble the organization
as it asks employees to do more while their wages shrink in real terms. In
that case, the organization would want to give a minimal 3% raise. The net
one-year savings from the hiring freeze would then be about 2.15 percent.
Salary costs are just one aspect of the overall organizational financial
equation that would need to be analyzed, and additional interaction and
offsetting effects would be encountered.

Across-the-Board Cuts

In some ways, across-the-board cuts are the easiest to administer. The

primary analytical effort rests in determining the amount to cut. For a
government agency or institution, the percentage may have been legislatively
mandated. In other cases, the organization needs to determine the
percentage for itself. When an organization makes across-the-board cuts, the
percentage is usually set and then managers are asked to develop proposals
for achieving the cuts in their areas. This gives them the flexibility to make
the cuts where they will do the least damage to their operations. If their
budgets contain any slack, managers will identify these areas and cut them
first.

The organization may decide to consider multiple levels of reduction

proposals, asking for budget reduction proposals at the levels of 10 percent,
20 percent, and 30 percent. This process allows leadership to evaluate the
degree of cut that can be sustained in light of the disruption to programs and
services. If leaders cannot accept higher levels of cuts, they may renew their
efforts to increase revenues to respond to the financial problem.

Across-the-board cuts have "surface" fairness, but they are indiscriminate.

They do not account for differences in units' ability to absorb cuts, in their
starting level of budget flexibility. Therefore, the organization may choose to
pursue targeted cuts in which it identifies the best opportunities to reduce
budgets.

Targeted Cuts

Targeted cuts can be identified and chosen by leadership itself, or through a

participatory process. Leadership may make the cuts by deciding at a senior
level where cuts can occur to achieve the required reduction. Each officer

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might offer to cut certain things in his area. A more participatory process
involves more managers in identifying opportunities to reduce budgets.

Targeted cuts will start with a search for excess funding that may have been
used in the past but is not entirely necessary to maintain programs and
services at a minimally acceptable level. Units will also look for places in
which they can hold positions vacant without undue disruption to
services. Targeted cuts may extend to higher-impact decisions such as ending
certain services, closing programs, or cutting back on support services. Such
strong cost-cutting moves will tend to bring larger reductions in costs but will
come at a higher cost in organizational morale and external relations.
Therefore, it is crucial that these decisions be consistent with the
organization's core strategies and with the interests of the key clients,
customers, or constituencies.

A participatory approach to targeted cuts may require more cooperation and

voluntary sacrifice than managers can muster. In that case, leadership may
choose a select group of staff or may hire consultants to try to find these
opportunities for cost reduction.

Although somewhat more extreme than most of the examples cited so far, an
organization that needs to reduce costs significantly may decide that it needs
to undergo a major restructuring. This would involve reevaluating the
services it offers, reassessing how many departments and managers it should
have, taking a fresh look at how many and what kinds of staff it has, and
developing fundamentally new models for such things as the use of
technology in its operations and service delivery. An organization may decide
it must restructure if it determines that its financial problems are due to
major changes in its service delivery arena. Perhaps the populations it serves
has changed, or new options for serving those needs have emerged. Once an
organization decides it needs to restructure, it has definitively moved from
the realm of budgeting to that of strategic planning.

Process or Technology-Driven Cuts

One way to target cuts is to link them to process or technology changes. The
organization's staff and/or consultants analyze processes to identify ways to
change procedures or apply technology that will reduce the work required.
Once processes are changed and technology is installed, positions and other
costs can be eliminated.

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This strategy usually will not produce net savings in the short run. The
changes usually require time to implement — suggesting that an
organization may adopt deficit budgets as it goes down this path. Also, this
strategy may involve a shift from operating costs to capital as new technology
is acquired. Capital costs will not immediately hit the operating statement as
a drain on net income, since for accounting purposes they are treated as a
transfer of assets from one asset category to another, but they may strain the
organization's cash balances.

Moreover, the long-term costs of the capital investment, in terms of

depreciation, replacement, and ongoing support must be evaluated against
the realistic savings projected in other cost categories. Still, process or
technology changes do have the potential to produce substantive changes in
the way an organization does business. These can result in structural,
sustainable reductions in cost. By contrast, organizations that implement
across-the-board cuts often find that the costs return quickly after the sense
of crisis and the period of intervention begin to lift.

It is important to remember that cutting budgets and cutting costs are not
the same thing. Cutting the budget gives the organization a plan for lower
spending, but achieving this plan requires discipline in specific decisions on
hiring and buying made throughout the year. An organization with a strong
culture of taking budgets seriously and managing to budget will find that
reducing budgets results in lower spending by managers.

However, it may be necessary to adopt additional policies and procedures in

order to enforce lower spending consistent with the reduced budget. These
may include a freeze on filling vacancies and the establishment of a review
process for exceptions. Any time managers are required to achieve budgeted
cost reductions, budget performance must be incorporated in a rigorous
performance evaluation system that reinforces the need to achieve specified
financial goals.

Making Decisions on Budget Cutting

Organizations have several options for cutting budgets, but they still must
decide how much to try to cut, over what time frame, and choose an approach.
First, the organization's leaders need to have a clear understanding of the
nature of their deficit.

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 • Is it a cash deficit, an operating deficit, or both? The organization's
full operating statement may show a deficit, but most operating
statements will include non-cash items such as depreciation. A non-
cash deficit is a serious matter, because the organization is not
generating the resources to replenish itself, but the negative effects
may play out over a longer time frame, giving it more time to develop a
response.
• How strong are cash balances? Deficits pose a much more immediate
threat to an organization with low cash balances, leaving it with much
less room for error in assessing the situation and developing the
response.

Once the organization understands these basic facts about its deficit, its
leaders need to consider the following factors in making the decisions about
how to cut budgets and costs. First, they must consider:

•Existing budget rules. Certain budgeting systems include explicit or

implicit rules about how to handle budget deficits. If the organization
has adopted a Responsibility Center model (see Chapter 16), in most
cases the managers of units which have run deficits will have the
responsibility for reversing those deficits within their own unit's
finances. An organization may have an understanding that once
certain budget resources have been allocated to units for the year, they
will not be taken back mid-year-therefore midyear adjustments must
come from resources over which the central administration retains
control. A deficit can get bad enough that an organization must
suspend its rules due to the extreme exigency of the situation. In that
case, it is critical that leadership acknowledge that it is suspending or
changing the rules and be prepared to explain what about the situation
is so severe as to justify this strong response.

Within the context of these budget rules (or a period of exigency that requires
a suspension or change in rules), leadership needs to consider the following
issues:

• Time available for achieving a change in results. Does the

organization need to avoid a deficit in the current period, try to come
up with a balanced budget for next year, or develop a multi-year
recovery strategy? Financial considerations such as the size of cash
balances can drive this decision, but organizational policies or politics
can play an equally important role. The board may not accept deficits,

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 or leaders may find that tolerating deficits sends the wrong message to
the organization.
• Risk tolerance. Some strategies for cutting budgets and costs carry
more risk. Investing money in technology in order to bring about major
changes in the cost structure runs the risk that the cost savings
returns will not equal the investment. A major organizational
restructuring to reduce positions runs the risk of disrupting programs.
Holding reductions to a minimum while trying to boost revenues runs
the risk that the revenues will not materialize. The organization's
tolerance for riskier responses is a function of the organization's
culture, its resources, and the potential for positive changes in the
future.
• Dependence on and impact on external groups. The organization also
needs to assess the ways in which reductions could influence their
relations with external groups, such as clients, donors or volunteers.
Will cuts in certain services disadvantage the organization relative to
other groups that could serve the same client base, thereby reducing
its ability to win funding for its programs? Would cuts in certain
services or programs inconvenience or put off significant numbers of
volunteers who would then start giving their time to other
organizations? Are other entities poised to pick up clients, donors or
volunteers if the organization falters?
• Quality of information. Does the organization understand the
sources of its deficits, and does it understand costs well enough to
identify areas which might be better places to cut or which it can
restructure through process and technology changes? The information
can include how well it has articulated goals and strategies, and
whether those strategies have been linked to operating activities in a
way that allows the organization to make differential judgments about
how activities and cost areas contribute to achieving those goals.
• Quality of managers. Do the managers understand their operations
and costs well enough to help assess costs? Do they have the good
judgment to make recommendations that have the optimal impact on
costs without undercutting the organization or its programs? Do they
have the skill to implement major changes?

If leaders do not trust their managers, or do not trust them consistently, it

will be hard to adopt a program that pushes much of the decision-making
about budget cuts back onto the managers. Some recovery strategies, such as
implementing major process change in a way that reduces staff levels,
require significant management skill to pull off.

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 • Trust levels within the organization. Are the members of the
organization well-aligned around a common vision of the organization
and its situation? Do they work well together and support each other?
Has leadership succeeded in establishing communications within the
organization? Trust may need to extend to board members, donors and
volunteers as well.

The trust levels in the organization may determine its ability to accept
differential cuts, or for some units to sacrifice resources on behalf of the
whole. Establishing trust is a matter of behavior as well as communications-
leaders need to behave in ways that inspire trust. For example, if leaders ask
for some units to bear the brunt of budget cuts, they must make sure they
chose those cuts based on legitimate operating considerations, and did not
inflict cuts on managers or units which had fallen out of favor for one reason
or the other.

• Political clout of leadership within the organization. Does leadership

have the ability to align people behind a course of action and to
convince them to accept some moves which may be unpopular or
distasteful? When an organization needs to cut budgets, it often does
not have the time to wait for consensus to develop behind a response.
The organization's leaders may need to use political influence within
the organization to get people to go along with something.

If leaders do not have the political skills or weight, they may need to avoid
strategies which require higher levels of participation and collaboration from
people throughout the organization.

Based on their answers to these questions, leadership should develop its

approach to cutting budgets. In an organization with low trust levels and
relatively poor information, the best approach may be across-the-board cuts.
Although it has the potential for more sustained impact, relying on process or
technology changes is somewhat riskier, so it may be a better choice for an
organization which has a longer timeline for its recovery, resources for
investment, and management talent for implementation.

Communicating Budget Cuts

In addition to deciding how much to cut and what approach to take, the
organization's leaders need to determine how to communicate their actions to
the rest of the organization. Once people start to hear about budget cuts, they

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start to worry about their own jobs, programs and clients and about their
friends in the organization. Morale may decrease and distractions increase.

For these reasons leadership may want to keep its budget-cutting activity
quiet. This may be a good idea, especially if their actions can be discrete and
have minimal impact on members of the organization, such as negotiating
better rates when contracts come up for renewal or changing expenditure
patterns out of central funds.

In most cases, however, leadership cannot insulate members of the

organization from budget and cost cutting. Therefore, they must say
something about the reasons for taking action and about what will happen.
Each organization will need to make its own judgment about the amount of
information shared and the tone of it. It may not be appropriate or useful for
leadership to share everything it knows about its cost trends, although some
information about its specific expectations can be useful.

The organization also needs to decide whether to describe its situation in

terms of a crisis, or to soft-peddle it. Some writers on organizational change
have argued that an organization will change only if the people in it share a
sense of crisis and can mobilize themselves to respond to it, as a nation does
in time of war. However, in some situations the sense of crisis can get
exaggerated beyond the true scope of the situation, and distract people
unduly from the organization's normal business.

One way of looking at the decision about tone of the communications is to ask
whether this a situation in which the organization needs everyone to drop
what they are doing, roll up their shirt sleeves, and help dig out of this mess,
or is this a case in which people should know that the organization is facing
some difficulties, but leadership is working on it and is confident that they
can respond with minimal disruption, so people should just keep doing what
they are doing and be prepared to help out when they are asked.

In communicating about budget cuts, leadership needs to keep in mind a few

points:

• Assume that everyone is looking for the answer to one question—will

I lose my job? This means that everything said by or on behalf of the
organization and leadership will be scrutinized very closely, hunting
for implicit clues that suggest the extent of layoffs or that jobs will be
guaranteed or protected. This means that if a dollar savings target is
announced, some people will divide that by what they believe is the

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 average salary to come up with the number of positions they think will
be eliminated, even if there is no intention to cut positions. On the
other hand, an announcement that the organization expects to achieve
cost reductions through attrition may be interpreted as a guarantee of
no layoffs.
• Keep the messages clear. People can exercise selective hearing
during this process. If leadership tries to make an overly nuanced
pronouncement on the budget cutting process, the nuance may be
missed and people may hear a more discouraging or encouraging
message than was intended. If leadership has decided to try to place
everyone who wants one in a new job, but wants to retain the right to
offer a lower salary for the new position, they need to be careful not to
say something that is interpreted as a guarantee that no one will lose
their job and everything that goes with it-responsibilities, pay, etc. On
the other hand, in this case one would want to be careful not to suggest
that the organization is going to cut pay rates if that is not the case.
• Be careful what you promise. People will remember the statements
leaders make. The organization should be sure it won't have to lay off
people before anyone makes a statement that rules out layoffs or some
other painful move. Once the statement has been made, it either limits
the actions the organization can take or forces leaders to forget about
the earlier statement (usually people in the organization don't allow
these statements to be forgotten) or to recant it, exacerbating the
negative effects on morale and trust.
• Don't expect to make everyone happy. You cannot control everyone's
interpretation of events. Periods of budget cutting are difficult times,
and after making a good effort to communicate effectively,
management has to accept that some people in the organization will be
angry and will not accept the organization's "party line." Leaders will
move forward in spite of these sorts of difficulties, although they will
do what they can to reduce them. Communicating during a period of
organizational stress is not easy.

Many organizations find it useful to adopt a formal communications plan

early on in such a painful process. This plan would specify the audiences for
communications, the information they should receive, and the timing and
vehicles for communicating to them. Certain messages need to come directly
from the organization's leader, others can come from more immediate
supervisors. Often an organization needs both face-to-face communication of
information and formal documents that record and disseminate key elements
of the analysis, process and response.

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The organization should also assess the need for messages to outside groups,
including in some cases the local media. An organization which has a
significant profile within its community may find that the media start to pick
up news of its internal actions, and may need to take action to educate the
media about what it is doing.

───────────────────────────

David Maddox is a management consultant in KPMG's higher education

consulting practice. This article is excerpted from his new book, Budgeting for
Not-for-Profit Organizations. Copyright © 1999 by John Wiley &
Sons. Reprinted by permission of the publisher, John Wiley & Sons,
Inc. Other new titles in the Wiley Nonprofit Series include Tax Planning and
Compliance for Tax-Exempt Organizations, 3rd Edition, by Jody Blazek, a
complete guide for solving tax-exempt problems, which contains charts,
checklists, and practical suggestions for IRS examinations, measuring
reasonable compensation, managing lobbying expenditures, and more. All
Wiley Nonprofit titles are available from the Wiley Web set at
http://www.wiley.com or by calling 1-800-225-5945.

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