Dogged by cramped conditions and mounting financial losses, Palo Alto's scrappy but popular animal shelter is once again fighting for its life.

Three years after the city flirted with the idea of outsourcing animal services in the midst of a budget crisis, officials are again considering the future of a municipal operation that is now losing close to $900,000 annually. Though city officials are no longer talking about shifting animal services to another city, they are preparing for the possibility of "spinning off" most services to a private organization capable of making the needed investments, leaving only animal-control responsibilities with the city.

A new audit by the office of City Auditor Harriet Richardson underscores the steep problems facing the East Bayshore Road facility. Palo Alto Animal Services, the audit found, faces challenges that are "unlikely to be resolved if it continues operating as solely a city-managed function without a significant increase in general fund subsidy, donations, and/or revenue-generating contracts."

The City Council's Finance Committee discussed the audit Tuesday night and generally concurred with the assessment of both Richardson and City Manager James Keene that it's time to rethink the entire operation.

The shelter's financial calamities began in 2011, when Mountain View pulled out of its partnership with the shelter, taking with it the $400,000 in annual revenues that it had previously contributed.

Palo Alto tried to balance the books by reducing staff, but while that effort helped reduce expenditures, it didn't come close to replacing the lost funding. The animal operation currently has 10.66 full-time positions, down from 13.42 two years ago. And while privately run shelters generally rely on donations for much of their revenues, the city's policy prohibits directly solicited donations.

The loss of key personnel last year didn't help. When both of the shelter's veterinary technicians left, it had to temporarily close its spay-and-neuter clinic. While the operation has historically generated about $190,000 in spay and neuter fees annually, but in fiscal year 2014 it only brought in $47,500. The city ultimately hired two new veterinary technicians but ended up firing one near the end of the fiscal year.

The impending retirement of the shelter's supervisor creates another hurdle.

Then there are the facility's conditions. Though the audit cites surveys showing that customers deeply value and appreciate the local shelter, other cities are a different matter. Its cramped and outdated conditions make it difficult for the city to find a new partner that would contribute the revenues that were lost when Mountain View withdrew. The audit notes that existing Palo Alto Animal Shelter facilities "are outdated and inadequate to meet modern animal-care standards, and the City has not successfully completed projects to refurbish and renew the shelter over the years."

Senior Performance Auditor Houman Boussina highlighted a list of problems with the current facility: its general lack of space, cramped kennels that in some cases have sharp edges, porous flooring and a lack of a separate receiving-and-intake room. At times, small animals are shelter in staff's lunch room, which presents a health hazard.

"It has outlived its useful life and does not meet the modern standard of animal care," Boussina said.

The audit offered a series of recommendations with which Keene and the council generally concurred. They include assigning a manager to oversee the animal shelter's transition into the future; conducting a cost-benefit analysis to consider expanded hours for the shelter; engaging nonprofit organizations and other shelters in discussions of operating the shelter; and assessing the feasibility of obtaining funding for a new shelter through fundraising, public-private partnerships, General Fund subsidies or a bond initiative.

About the recommendation to separate the animal-control service from the shelter, Keene stated in his response to the audit: "This will be done. At this time, the City Manager presumes that bifurcation of the duties will be our future approach, maintaining (animal control) operations within the city and spinning the shelter off to a nonprofit entity in the longer term. This assumes the shelter will remain in Palo Alto."

The Finance Committee will begin considering on May 6 specific budget proposals for keeping the animal shelter afloat and for planning its future. This includes budgeting an additional $200,000 to $300,000 for transition costs, which would include hiring additional staff or a consultant with experience in managing shelters, Keene said Tuesday.

Keene pointed to the financial data and noted that the numbers "are going in the wrong direction."

The shelter had a net loss of nearly $894,000 in fiscal year 2014, which went up to about $911,000 last year. So far in the current fiscal year, which ends on June 30, the shelter has lost nearly $618,000. The numbers, Keene said, "are a reflection of the fact that the operation, as we have it now, the structure in my view clearly doesn't work."

The committee concurred that the animal operation is not sustainable in its current state. Councilman Eric Filseth noted that at least another $2 million will be "flushing down the hole" before any major change is made and asked if the transition period could be shortened.

Vice Mayor Greg Schmid, who chairs the committee, also said he was struck by the severity of the shelter's losses.

"The financial figures are quite dramatic," Schmid said. "It is striking to see that we've been losing a substantial amount of money for a number of years."

The audit won praise from the committee and members of the public who attended Tuesday's meeting. But local resident Barry Hayes took issue with any suggestion that the city can't operate an improved shelter. He encouraged council members not to view the service strictly in economic terms.

"I don't expect you to say fixing potholes is 'flushing money down the hole.' I don't think it should be expected to be the profit center," Hayes said.

Keene agreed that it's not just about the money, but noted the city would not find these types of losses acceptable in other municipal operations, whether utilities or senior services.

"I don't like us being in this situation. I don't like us losing this kind of money," Keene said. "I don't mean to say it's just about money. Hearing from folks and the different perspectives, it's very clear that the facility and the operational standards we expect in our city are not being met in our current operation. We would not apply this approach in other service areas and we need to fix it."

The most likely prospect at the moment is a partnership with Palo Alto Humane Society, which has already made two different offers to the city. In the first offer, it proposed to raise money for an expanded facility. The nonprofit subsequently revised its offer and is now proposing to focus on expanding the shelter's services and educational programs.

Carole Hyde, executive director of the Humane Society, presented to the committee her vision of the local shelter as a modern facility that functions like a "community center" with vibrant programs, enhanced outreach, social activities, foster programs and school field trips.

"A shelter for Palo Alto must be a community center to thrive -- a community center to involve the people of Palo Alto, bring them to the shelter and encourage them to embrace the shelter as their own," Hyde said.

Keene noted that a shift to a different model of operations could improve, rather than displace, the local operation.

"More than anything, folks and staff see this as not just plugging up a hole or resolving a deficit, but really improving and enhancing the service here in the city, and it's an opportunity," Keene said.