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Monday, June 29, 2015

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Fixing the Overhead Myth


Although the nonprofit sector is taking steps to end the “overhead myth,” which equates low overhead with success and ignores other critical factors, many organizations are still measured by their financial ratios and spending instead of their outcomes. This misguided approach can threaten a nonprofit’s mission and its long-term survival, so organizations need to educate funders about the true cost of their work and shift the focus to their results.

Low costs don’t mean high performance
A nonprofit has three main categories of expenses. Program costs are those directly related to the activities for which a nonprofit exists. Fundraising costs are tied to the activities an organization undertakes to obtain contributions. Management and administration costs are not identifiable with a specific program or fundraising activity, but are essential to the conduct of those activities and to the nonprofit’s existence. This includes things like management salaries, utilities, equipment and other infrastructure costs. Together, fundraising costs and management and administration costs make up overhead costs.

Although overhead allocation is an important metric to track―it can be used to spot fraud or poor financial management, for example―it is misleading when viewed by itself, because it shows nothing about a nonprofit’s impact, such as how many people a soup kitchen feeds or a homeless shelter houses. Yet many funders are still mistakenly tied to the notion that low overhead means an organization is highly effective, and high overhead means it is a wasteful poor performer.   

Nonprofits have been judged by their overhead for decades, but the metric has become more influential in recent years with the rise of big data analytics and charity rating sites that focus on financial ratios, as well as the public’s demand for quick statistics to gauge a nonprofit’s performance. Donors have adopted the false mantra of “low overhead equals success” and have relied on rating sites as an easy-to-use indicator of an organization’s effectiveness.  Nonprofits also have made the problem worse, by highlighting their low overhead and ratings in their fundraising materials. 

The dangers of insufficient overhead
Buying into the overhead myth can jeopardize an organization in several ways. A nonprofit that focuses solely on keeping overhead costs low is likely to defer spending on employee training, technology and other critical investments, and this can threaten its day-to-day mission as well as its long-term viability. Outdated software may limit an organization’s ability to execute a successful online fundraising campaign, for example, or poorly trained staff may not have the skills to do their jobs effectively.    

Nonprofits may also be motivated to misclassify overhead expenses as program costs. This puts them at risk of not knowing their true overhead costs―a danger for any entity, because management relies on accurate financial information to make informed and strategic decisions. Underreported overhead costs may lead management, funders and stakeholders to conclude that the organization is running effectively and that overhead spending is sufficient, when in reality, the exact opposite is true.

It’s not unusual to see nonprofits report implausibly low fundraising expenses. The 2004 Nonprofit Overhead Cost Study, a project conducted by the Urban Institute and the Center on Philanthropy at Indiana University, found that 37% of nonprofits with private contributions of $50,000 or more reported no fundraising or special event costs in 2000. In addition, nearly 13% of the operating public charities studied reported spending nothing for management and general expenses.

These effects are part of the “nonprofit starvation cycle,” a term taken from the title of an article in the Fall 2009 Stanford Social Innovation Review. In this vicious circle, funders have unrealistic expectations of how much it costs to run a nonprofit, which results in nonprofits misrepresenting overhead and underspending on vital costs, which then further perpetuates the funders’ skewed and unrealistic expectations. The end result: Nonprofits are constantly asked to do more with less.

How much overhead is enough?
So what is the right amount of overhead? There is no single answer, or even a general range, because it depends on so many variables. Is an organization young and still building out its infrastructure, or is it already established? Is it launching a new program or expanding to a new location? Any of these factors can significantly impact a budget, so each nonprofit must analyze its needs and make its own determination.  

Although not a perfect analogy, comparing the cost structure of a nonprofit organization to that of a for-profit company can offer some telling insight into the reasonableness of average nonprofit overhead costs. A for-profit organization typically incurs overhead expenses at an average of 25% to 30% of total expenses. Successful, highly innovative companies such as Google and Apple invest heavily in human capital and infrastructure, and report significantly higher overhead. Imagine the results if nonprofit overhead expectations were applied to the for-profit sector, and for-profit companies were asked to keep overhead costs below 20%.

Solving the problem
An inadequate overhead budget can slowly destroy a nonprofit’s ability to meet its mission, yet donors want to see low expense ratios. It’s a longstanding dilemma that will take time to solve, but it can be fixed.

The first step is figuring out what it really costs to run your nonprofit effectively. Determining this takes cooperation from your entire organization, so you need to educate every staff member about why the information is so critical. For example, everyone needs to understand the importance of accurately tracking their time and reporting it on their timesheets. The accounting department needs to be well trained on how to allocate functional expenses, and the tone from the top should stress the importance of accurately reporting costs.

After you’ve determined your true costs, you need to report them and educate your stakeholders about them. You have to show what your organization requires to operate effectively and tell funders how their dollars are being used.  What does it cost to provide an after-school program for each at-risk teen, or how many breakfasts does their contribution buy for hungry kids?

Maintaining transparency with donors and stakeholders is the key first step toward ending the overhead myth. As part of maintaining transparency and building that trust, nonprofits also need to identify and report the true costs of their organization. As more organizations determine their costs and better communicate the story behind them, nonprofits can shift stakeholders’ focus to the most important measure of their success: the outcomes they achieve.

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