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Improvements in the management of nonprofit organizations are proposed. It is demonstrated that modern management accounting techniques to improve management of commercial for-profit organizations apply as well to nonprofit organizations such that nonprofits should adopt the commercial for-profit methods of management accounting, including standard costs, flexible budgets, and variance analysis. The intent is to advise managers of nonprofits under severe financial pressure using the example of the Tel-Aviv Hospital illustration, which assumes that the people at the hospital are honest, capable, and primarily concerned with satisfying their patients in terms of the care they receive as indicated by the contributions patients make to the hospital. Hospital managers have a control over prices they pay for input resources with some control over the length of inpatient stay, the number of radiology diagnoses, the number of laboratory tests, and the units of pharmacy. Following FASB Statement No. 117, which requires aggregated financial statements, hospital managers cannot see their central problem - the hospital's deficit where subtractions from general funds exceed additions to those same general funds. This situation only becomes visible with disaggregated funds based statements.

This article proposes improvements in the management of nonprofit organizations, such as government, healthcare, education, charity, religious, and research organizations. Nonprofits especially need suggestions on improving management because for-profit organizations have the discipline of profits. The role of profits in for-profits organizations is a powerful discipline for financial management, and is basically Adam Smith's theory of free markets in which an unseen hand guides economic resources to where the greatest profits can be expected. For this theory to operate it is critical that investors have financial statements with adequate disclosure and transparency.

The FASB, in their revolutionary Statement Number 117, requires nonprofit organizations to present an aggregate view of the entity and not to use a disaggregate or fund-accounting format. The alternative argument would be that nonprofits should present disaggregate fund-based statements as supplementary information. A leading text in nonprofit accounting states the following regarding government fund accounting system as a:

. . . method of segregating assets, liabilities, and fund balances into separate accounting entities associated with specific activities, donor imposed restrictions, or obligations. Similarly, a fund accounting system makes it possible to determine compliance with laws, regulations, and agreements and to demonstrate that the NPO is meeting its stewardship responsibility to resource providers. Many NPOs still use this accounting method for internal management and grant-reporting purposes. As mentioned previously, SFAS No. 117 permits not-for-profit organizations to also present disaggregated data classified by fund groups as long as the aggregated net asset statements are also presented.1

This article demonstrates that modern management accounting techniques to improve management of commercialfor-profit organizations apply as well to nonprofit organizations such that nonprofits should adopt the commercialfor-profit methods of management accounting, including standard costs, flexible budgets, and variance analysis. The intent is to advise managers of nonprofits under severe financial pressure using the example of the Tel-Aviv Hospital illustration, which assumes that the people at the hospital are honest, capable, and primarily concerned with satisfying their patients in terms of the care they receive as indicated by the contributions patients make to the hospital. This in turn supports Anthony and Young's statement: "... that the basic concepts of management control are the same in both for-profit and nonprofit organizations."2

Detailed hospital financial statements reveal that the deficit of $163,500 in the change in fund balance of the general funds is the most meaningful bottom line for the hospital, indicating severe financial pressure. This deficit could cause the hospital to reduce services and possibly lead to bankruptcy. The hospital survived the year only through a $100,000 additional mortgage from their bank and by borrowing $80,000 from the hospital plant fund. A large backlog of donations earmarked for plant assets is increasing, causing the hospital to lag substantially in fulfilling donor wishes for plant expansion.

Information suggests that the hospital should adopt a standard cost system-a system of standard costs, flexible budgeting, and cost analysis that has been around for long time for manufacturers. Horngren cites a survey that seventy-six percent of US manufacturers use standard costs and that the most important reason they give is improved cost management.3 Robert S. Kaplan and H. Thomas Johnson argue that such a system has been part of 19th century cost management systems:

There is ample evidence that manufacturers around 1900 used information on variances between actual and standard costs to control their operations. Credit for writing the first published description of modern systems for analyzing standard cost variances goes to management consultants, Harrington Emerson and G. Charter Harrison. Harrison followed Emerson and became the first person to publish a set of equations for the analysis of cost variances. Emerson was perhaps the first writer, however, to stress that information about standards permits managers to differentiate between variances that are due to controllable conditions and variances that are caused by conditions beyond managements' control, an idea that management accountants many years later would associate with flexible budgeting.4

Tel-Aviv Hospital

Tel-Aviv Hospital accepts patients of a wide variety of cases. Exhibit 1 shows the standard variable cost of four cases: DRG089 (pneumonia), DRG014 (cerebral disorders), DRG096 (bronchitis), and DRG140 (angina pectoris), although the hospital accepts patients for hundreds of different case diagnoses. Assuming that these four are the only cases in the hospital, Std Q¿ represents variable standard hospital resources required, and Std Vj represents variable standard hospital resource costs. Since pricing and inventory valuation are not objectives of the standard-cost system, this illustration focuses on the standard variable cost of a case and also assumes that the hospital separately invoices the patient for the surgical bill and for the cost of the medicine prescribed.

After preparing the standard variable cost of the cases it treats, the hospital must prepare a static budget. The budget becomes the basis for performance evaluation and aids in the planning and coordination of all hospital activities. There are significant uncertainties as managers obtain numbers to prepare the budget. Hospital managers cannot predict the number of patient admissions or the mix of diagnoses. Similarly hospital managers are challenged in terms of price predictions, which depend on the mix of diagnoses across private and public thirdparty insurers. As the hospital managers can make reasonable estimates of the number of cases that the hospital will treat and an approximate price for each case, Exhibit 2 shows the static budget for the year. The hospital expects a surplus of $73,650 for treating 650 patients, but as the year passes the actual results appear in Exhibit 3.

Though the hospital treated more patients than they had anticipated (700 versus 650), instead of the projected profit of $73,650 the hospital suffered a loss of $125,475 for the year. The job of the cost accountant is to analyze and explain this $199,125 difference. Before doing detailed variance analysis a flexible budget must be prepared using the actual number of cases (see Exhibit 4). According to the flexible budget, the hospital should have been able to show a profit of $206,025. Accountants must accordingly explain a greater disparity - between the loss of $125,475 and the unrealized profit of $206,025 - or $331,500. Exhibit 5 shows these flexible budget variances.

The hospital received $150,000 less revenue because prices to the patients were less than anticipated in the budget. This may be due to a less favorable mix of third-party insurers. The $147,000 unfavorable variance in variable cost and the $34,500 unfavorable variance in fixed costs are far more serious to managers because these are costs that managers can directly control. Exhibit 6 presents the detail of the $147,000 unfavorable variance in variable cost.

In Exhibit 6 the $147,000 unfavorable variance is divided to $64,500 favorable variance in prices of input factors and $21 1,500 unfavorable variance in quantities of input factors. The hospital appears successful in terms of controlling the prices they pay their suppliers but unsuccessful in terms of the quantity of input factors. The length of stay of inpatients, the number of radiology diagnoses, the number of laboratory tests, and the units of pharmacy exceed the standards of Exhibit 1. This may be the root of the deficits of the hospital and the cause of its severe financial pressure.

Conclusions

It is important to understand that the sources of equity for nonprofits are not investments by outsiders who seek a return on their investment. Rather, the sources of equity for nonprofits are contributors and governmental and organizational units. Nonprofits should report on their financial statements how well they are adhering to the wishes of the contributors of their equity.

Managers of nonprofits should also concentrate on controllable factors. Hospitals have limited control over number, cases, and types of patients. Hospital managers have a control over prices they pay for input resources with some control over the length of inpatient stay, the number of radiology diagnoses, the number of laboratory tests, and the units of pharmacy. Following FASB Statement No. 117, which requires aggregated financial statements, hospital managers cannot see their central problem - the hospital's deficit where subtractions from general funds exceed additions to those same general funds. This situation only becomes visible with disaggregated funds based statements.

[Footnote]

NOTES

1 Wilson, Earl R., Kattelus, Susan C, Reck, Jacqueline L., Accounting for Governmental & Nonprofit Entities, 14th edition, McGraw-Hill Irwin, 2007. 575.

2 Anthony, Robert N. and Young, David W., Management Control in Nonprofit Organizations, 7th edition, McGraw-Hill Irwin, 2003.

3 Charles T. Horngren, Srikant M. Datar, and George Foster, Cost Accounting A Managerial Emphasis, 12th edition, Prentice-Hall, 2006, page 229.

4 H. Thomas Johnson and Robert S. Kaplan, Relevance Lost, Harvard Business School Press, 1987, pages 50-51.