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Editors’ Note:  As the articles in this issue of the Nonprofit Quarterly demonstrate, nonprofits cannot escape the need for careful financial management faced by other types of institutions. But as these articles also make clear, the financial management tasks faced by nonprofits are also different, in both scale and kind, from those facing business and government institutions. The purpose of this article is to explain why that is the case and what the implications are for the financial management tasks confronting nonprofit institutions.

At the heart of the dilemma that underlies all nonprofit management is the fact that American nonprofit institutions operate in the context of a market economy, yet they are not fundamentally market institutions. They are “in” the market but not “of” the market.

Like other institutions, nonprofit organizations must generate income to cover their costs. They have to pay staff, buy supplies, acquire equipment, secure space, arrange fringe benefits, insure themselves against liability and losses, and manage their cash flow. In short, they must engage in all the financial and economic functions of any private institution. Not surprisingly, the techniques of market-based financial management are therefore highly relevant to their financial management tasks.

While they are obliged to operate within the confines of a market economy, however, nonprofit institutions are not true market institutions. They therefore have to take care not to fall too headlong into the embrace of market-based financial management, seductive though it may at first appear.

Fundamentally, what makes nonprofits different from other private institutions is that nonprofits have what economists call a different “production function.” This is shorthand for the idea that what nonprofits are trying to achieve (to “maximize” in “economics speak”) is different from what businesses are trying to achieve. For businesses, the goal of production is to maximize profits. To be sure, businesses sometimes find that to maximize profits they must also do other things–such as treat their employees well, produce good products, develop a reputation for reliability, and even make charitable contributions. But the fundamental purpose of business production remains the maximization of the bottom line. While it is no easy task to determine how best to do this in a fluctuating market environment, this clear production function nevertheless lends a certain simplifying quality to for-profit management.

Nonprofits have a much harder task. While they can hardly ignore the bottom line, it is not the ultimate definition of their success (at least it shouldn’t be). Rather, it is organizational mission that defines the “production function” of nonprofits. Managers are supposed to run their organizations in such a way as to maximize their influence on the reduction of hunger, the promotion of scientific advance, the pursuit of cultural excellence, the relief of poverty, the empowerment of the poor, or some other somewhat nebulous objective. This makes the task of nonprofit management both harder and easier than for-profit management—harder in the sense that the connection between means and ends is even more difficult to gauge than it is for businesses; easier in the sense that it’s more difficult to tell whether the goals are being met or missed.

This difference in production function is not merely theoretical. It finds tangible reflection in a number of other differences between for-profit and nonprofit enterprises. Let us consider a few of these:

Nonprofits have a significantly different structure of costs than most for-profits. For one thing, nonprofits are not taxed. For another, they tend to be concentrated in labor-intensive industries, so labor costs constitute a larger proportion of costs than in the economy more generally.

Nonprofits also have different revenue structures than most for-profits, though this difference has narrowed in recent years. Most obviously, nonprofits have access to philanthropic revenues that are generally not available to for-profit firms. This leads to forms of revenue-generation that have no counterpart in the for-profit sphere (fundraisers, pursuit of foundation grants, attraction of wealthy donors). It also creates a class of nonprofit “stakeholders” whose impact on nonprofit operations can easily exceed that of the organization’s “customers.” More recently, nonprofits have also come to depend heavily on public-sector funding, which creates its own dynamics and expectations. As the forms of government support have grown more complex–through the adoption of third-party reimbursement systems, loan guarantees, and tax subsidies, for example—this has required specialized marketing and financial management skills.

Nonprofits also differ from for-profits in their access to capital. Capital is income used for long-term investment as opposed to operating income. For-profits can generate capital from two sources not regularly available to nonprofits: from excess income and from the issuance of stock (equities). Nonprofits can sometimes pursue the first of these courses, though some of the major sources of their revenue (government and donors) generally frown on this. The second course–the issuance of stock–is completely unavailable, since nonprofits are forbidden from sharing any profits with a set of owners or directors. What’s more, they also are forbidden from distributing any assets they might possess. Under these circumstances, no one would buy stock in a nonprofit, since such stock would essentially be worthless.

This interest-free source of capital for expanding plant or purchasing equipment is therefore not available. Governments have responded to this problem for certain classes of nonprofits (universities and hospitals, for example) by authorizing the issuance of tax-free bonds that attract investment capital. But such bond financing is not available to all nonprofits, and it carries interest costs, albeit at somewhat lower rates than regular market loans. This makes the challenge of raising capital especially difficult for nonprofits and helps explain why for-profits have been able to gain market share in periods of rapidly expanding demand for services.

Nonprofits also have a different human resource structure than for-profits. For one thing, they have access to volunteer labor, which can extend their reach without adding to their labor costs. In addition, they attract workers with a commitment to their missions. Both of these can yield important advantages if properly managed. Recent studies have shown, for example, that nonprofit workforces are far more intrinsically motivated than their for-profit or government counterparts (see “The Content of Their Character: The State of the Nonprofit Workforce,” in the Fall 2002 issue of the Nonprofit Quarterly). Indeed, for-profit firms have recently tried to emulate the mission-driven nature of the no