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Nonprofit Finance Theory
The role of "earned income" in nonprofit revenue in the context of the overall theory of financing nonprofit organizations 

by Dennis R. Young
01/01/04

So far in this series, I have explored the conceptual basis for two sources of nonprofit revenue – charitable contributions and government funding (see the June and October newsletters on our website). In this installment, I address the role of “earned income”.

As a relevant aside before we get started, let me note that the idea of developing an overall conceptual framework for nonprofit finance is starting to catch on. I had the privilege of chairing a session on this subject at the recent ARNOVA meeting in Denver in November – with a distinguished panel consisting of Arthur Brooks (Syracuse U.), Patrick Rooney (Indiana U.), Maxim Sinitsyn (Northwestern U.), Woods Bowman (DePaul U.) and Kevin Kearns (U. Pittsburgh). We had a standing-room-only crowd of enthusiast participants for our discussion. The momentum of that session is propelling us to organize a formal project that will examine in depth, all of the major alternative sources of nonprofit resource support, as well as the principles upon which different income streams can be combined into effective resource portfolios.

The term “earned income”, defined here as revenue from sales of goods and services in the private marketplace, constitutes the largest proportion of operating revenue for U.S. nonprofit organizations, outweighing both government funding and charitable contributions. Of course this proportion varies widely among fields of services, and even among nonprofits within particular fields of service. All this compels us to ask – under what circumstances is it appropriate for nonprofits to earn their money through fees and sales?

This question contains a number of issues within it. First, we need to ask about the kinds of goods and services it is appropriate for nonprofit organizations to sell in the marketplace. Second, we need to ask whether the nonprofit should seek to earn a profit, break-even or run at a loss while collecting fees for such services.

The answer to the first question has three parts. First, there are certain types of goods and services which theory argues may be more efficiently provided, from a social point of view, by nonprofits than by for-profit businesses. Second, there are certain types of goods and services for which nonprofits may have no particular social efficiency advantages, but which they may nonetheless be able to provide efficiently on a competitive basis in the marketplace. Finally, there are services which may be relatively straightforward commercial services for which the nonprofit has no particular competitive or social efficiency advantages, but which provide market-based vehicles for pursuing social missions and producing social benefits. Let’s take each of these cases in turn.

First, what kinds of so-called “private” goods and services might be more efficiently provided by a nonprofit organization, than by a profit making business, from the viewpoint of society? Economist Henry Hansmann argued that for certain types of goods, a condition of “contract failure” exists such that consumers experience an information disadvantage relative to producers. Hence, consumers fear exploitation and will not consume as much as they want unless they can patronage trusted suppliers. Examples include very complex services such as higher education which consumers have difficulty evaluating for themselves, and services such as child day care or nursing home care for the frail elderly that are purchased by proxy consumers (family members) and cannot be directly experienced or sufficiently monitored. In these circumstances, it is argued that for-profit businesses have an incentive to skimp on quality in order to maximize profits, while nonprofits are not so compelled. So, in markets for services involving contract failure, nonprofits can justifiably support themselves with fee income, given their ability to compete effectively with for-profit suppliers by overcoming consumers’ reservations about the quality of services or the likelihood of receiving good value for their money.

Another social efficiency rationale for nonprofits to provide services in the marketplace, and finance them, at least in part, with fees, relates to the concept of “external benefits” discussed in earlier installments of this series. In particular, there are some services that have a mixed “public/private” character, but which are sufficiently “private” to allow support from sales revenue. Examples include elementary schooling, job training, preventative health care services, museums and performing arts. In such cases, there are public benefits associated with private consumption. Preventative health care services reduce the spread of disease, education makes for a more informed body politic, attendance at fine arts performances promotes and preserves society’s cultural heritage, and so on. However, on their own, consumers will only purchase as much of these services as is justified by the private benefits they experience. And for-profit suppliers (unless they are subsidized) will respond only to this private component of demand, as manifested in consumers’ willingness to pay. As a result, such services will be under-consumed from a social point of view. Nonprofits with services, by charging lower fees supported by various other sources of income and/or foregone profits.

In addition to these two cases, where from a social viewpoint, a nonprofit may provide fee-based goods and services more efficiently than a for-profit business, there are other instances where the nonprofit may favorably compete in the marketplace because of cost advantages or unique product characteristics. Nonprofits may have a number of different types of costs advantages. First, they may be able to offer certain marketable services that are complementary to the nonprofit’s mission-related work and involve little extra cost. In this case the nonprofit can exploit “economies of scope” or “complementarities” between its mainline services and others which may earn it additional income. For example, if a museum has a nice exhibition area, that space may be easily rentable as a good place to hold a wedding reception. If it operates a parking garage for its visitors, it may be able to lease that space for other customers outside of museum hours.

Alternatively, a nonprofit organization may exploit certain “economies of scale” in its operations. For example, a hospital may find it more efficient to run its own laundry service, given its volume of operations. Moreover, it may be in a position to make additional income by offering its laundry services at low cost to other customers such as nearby nursing homes or hotels or even its own staff. Note that in this compilation of cost advantages, I have not included tax privileges, volunteer resources or charitable contributions that can be exploited to subsidize prices or provide a competitive advantage. This is intentional because these advantages are artificial and do not represent real cost advantages that would allow nonprofits to produce services with lower real resource costs to society. Favorable tax treatment represents a financial transfer from government and taxpayers. “Free” labor is a transfer of real value from volunteers.

Charitable financial contributions are a transfer from donors. These sources of support may be used to subsidize nonprofit services where appropriate (as in the case of externalities), but they should not be used to rationalize the sale of goods or services that are not otherwise justified. In other words, tax advantages and charitable support are not a reason per se for offering a given good or service for sale even if such advantages would allow the nonprofit to compete successfully with commercial suppliers.

In addition to services for which it has cost advantages, a nonprofit may have unique expertise or it may have a very special reputation, characteristics that can translate into special “niches” in a regime of “monopolistic competition”. For example, an environmental organization may have unique knowledge of wetlands ecology that can be valuable to business corporations seeking to control pollution from their operations. Or, an orchestra or a museum may be especially prestigious or well-loved in its locality, allowing it to have a certain market advantage in selling tee shirts or other gifts bearing its logo. These unique characteristics of a nonprofit’s products allow it to compete efficiently and legitimately in a marketplace with commercial providers, and hence to generate income for itself through sales.

Third, in addition to those instances where market-based services are justified on the basis of social efficiency or legitimate competitive advantage, there is the case of “social enterprise” types of goods and services, where nonprofit organizations operate commercial businesses and use these businesses to advance their social missions. The clearest example is where a nonprofit runs a business as a vehicle to train and employ disadvantaged workers. The nonprofit may have no particular advantage in operating a restaurant, bakery, laundry or small manufacturing operation, and certainly such services per se do not involve any particular external social benefits, but such businesses may be the best way to prepare certain people for the world of work or to provide them with opportunities for a more fulfilling life. If a nonprofit can manage to compete in such markets, perhaps by exploiting lower wage costs or attracting consumers by signaling the charitable nature of its enterprise, then it may be justified in undertaking such ventures and hence raising revenues for it through sales. The underlying issue will be whether this is the most efficient way of generating the intended social benefits, particularly if the business is run at a loss or entails substantial subsidy from other sources of support.

Now to the questions of setting prices, making profits or running at a loss. In the case of contract failure, there is no reason for the nonprofit not to make a profit, so long as it delivers what it promises without compromise to the quality of service, in a manner that deals openly and honestly with the consumer, and where profits are used in a legitimate way to advance the mission of the organization. This conclusion may seem somewhat paradoxical since it may be argued that a policy of making profits on such services may set in motion a dynamic that leads management to skimp on quality in order to make more money. After all, nonprofits can always use more money, despite their constraints on use of that money. What is more important here, however, is that a nonprofit maintains its trust with consumers. That may entail keeping profits within modest bounds and providing full disclosure about finances and service quality. Nor does it seem advisable for the nonprofit to run such services at a loss. The whole idea of contract failure is that nonprofits provide a better alternative to consumers and ought to be able to compete successfully with for-profits where this condition holds.

The case of private goods (services) with externalities is a little different. Here, while the nonprofit is generally justified in charging something (unless the external benefits are overwhelming), it is also reasonable for the nonprofit to run its services at a loss. In this case, compensating support can potentially come from a variety of sources: straightforward subsidies can be provided from private contributions or government support; potential profits can be redeployed back into the operation so that services can be extended to more people; and various cross-subsidy strategies can be employed – for example, the use of sliding scales so that some consumers underwrite others; or use of profits from other services offered by the organization. (For a fuller discussion of nonprofit pricing issues and alternatives, see the chapter by Sharon Oster and Mel Gray in NCNE’s book, Effective Economic Decision Making by Nonprofit Organizations, Buy from Amazon.com.)

Where nonprofits compete in markets in which they enjoy a real competitive advantage, but where the connection to social mission is weak, the intent is usually to generate net income. So prices can be set to maximize profits within the context of demand in the marketplace, just as for-profit competitors would do. To the extent that externalities are perceived to be associated with these goods and services, however, the nonprofit may wish to modify its pricing policies, to induce greater sales at the possible expense of profits. For example, if a museum thinks that by selling replicas of artifacts in its shops at the mall or the airport, it will generate interest in visiting the museum, it might wish to make its prices more attractive.

Where nonprofits utilize market enterprises as vehicles for producing social benefits such as employment for disadvantaged groups, skills training, or the teaching of entrepreneurship, raising revenues through the charging of prices is again justified, though not necessarily at a level that maximizes profit. Without charging for sales of their products, these ventures cannot simulate a market experience, hence they would not produce the intended social benefits. Yet, such ventures, because they generate social benefits, can be justified even if they do not generate profits. Unless they also entail some special competitive advantages of the kinds considered above, these ventures will probably need some external form of support, in the form of lower wage costs, special government contracts, or subsidies that underwrite market losses.

Finally, any theory of the role of earned income must take into account the fact that nonprofits are more often than not, “multi-product firms”. Economists such as Estelle James and Burton Weisbrod have thus considered the role of earned income in the context of a nonprofit organization’s overall portfolio of services – some primarily intended to address the social mission of the organization, often at a financial loss, and others intended primarily to generate profits that can subsidize the former. For this and other reasons, the pricing of one service cannot be made entirely independently of the pricing of other services if the organization is to maximally address its social mission within the constraints of its overall resource generation potential. But this gets us into the question of income portfolios which I will reserve for a future issue.