Jan 09 The Overhead Conundrum

Nonprofits face multiple challenges in their day to day. While many of these challenges are like their for-profit counterparts, one area unique to the nonprofit community is overhead.

Overhead is defined as a nonprofit’s administrative and fundraising expenses and is typically viewed as a percentage of total expenses. These expenses include accounting, information technology, human resources, training, and management. While every company has overhead, only nonprofits are stigmatized by it. A nonprofit can be highly successful addressing their mission, but if donors perceive their overhead to be too large, that success could be held against them.

ORIGINATION OF THE OVERHEAD STIGMA

The perspective that a nonprofit’s large overhead is a negative was pushed by charity watchdogs and others looking for an easy way to grade nonprofits and help donors make informed decisions. Using the overhead percentage would reveal to donors how much of their contribution would go to actual program expenses versus overhead.

The idea was that the more a nonprofit spends on its programs, the more a donor’s money would directly impact the mission. Put in another way; it led to the belief that the best charitable nonprofits were the ones that spent less on these overhead costs. This standard is unique to nonprofits as for-profits are expected to spend on themselves to enhance operations and in-turn enhance their service offerings. Meanwhile, a nonprofit that demonstrates similar spending is deemed inappropriate as it diverts funds away from the causes the nonprofit is fighting for. This began what is now called the “overhead myth”, that overhead should define a nonprofit’s effectiveness.

THE MYTH ABOUT THE OVERHEAD MYTH

Based on published data from charity watchdogs, donors have developed unrealistic expectations of how much money it takes to run an organization. According to surveys, donors feel organizations should have 20% or less overhead rates. Many have said that when deciding whether to give to an organization, the overhead ratio is more important to them than the success of the organization’s programs. Meanwhile, fellow nonprofit foundations, who provide grants to their nonprofit counterparts, also fall under this line of thinking regarding overhead.

On average, a grant would cover at most 10-15% of an organization’s overhead, typically well below the amount needed to cover the organization’s costs. In a Grantmakers survey, 80% admitted that the overhead rates they cover in their grants are too low.

Nonprofits also pushed the belief that overhead was a bad thing. Many celebrated their low overhead rates and published them in promotional materials, further cementing into people’s minds that nonprofits should only have low overhead.

Additionally, many nonprofits have turned to misrepresent their actual numbers. A study on overhead costs found that 33% of nonprofits reported no fundraising costs despite fundraising activities, and 12.5% reported no administrative costs. The average overhead ratio ranged from 13-22%, but under additional scrutiny, the actual overhead rate was likely between 17-35%. These actions reinforce the unrealistic expectations of donors.

The impact of this myth has led to the nonprofit community cutting back on necessary infrastructure improvements to their organization for fear of raising their overhead percentage. This has a significant impact on the ability of a nonprofit to function properly. A nonprofit with poor infrastructure cannot properly track its program outcomes and show what is working versus what is not, poorly trained staff cannot deliver the quality services that its beneficiaries require, andunderstaffed organizations struggle to service their mission. Instead of revealing the most efficient nonprofits, this myth and mindset has created significant inefficiencies within nonprofits and unrealistic expectations for donors.

These unrealistic expectations and misrepresentation of data has led to what is now called the “nonprofit starvation cycle” pictured in Illustration A.

Illustration A

Thompson, Ken. “Social Justice and a Relevant Philanthropic Sector (Part 2).” The Aspen Institute Forum for Community Solutions, 29 Apr. 2020, https://www.aspencommunitysolutions.org/social-justice-and-a-relevantphilanthropic-sector-part-2/

THE IMPACT OF THE VICIOUS NONPROFIT STARVATION CYCLE

Without a necessary infrastructure or even fears of spending additional money on fundraising, nonprofits cannot grow. From 1970 to 2009, 144 nonprofits crossed the $50 million revenue barrier. In that same time frame, 46,136 for-profit companies crossed that same barrier.

Nonprofits, like any organization, need to invest in their people and technology. In the current environment, executive directors are often underpaid for the work they are doing, and the staff sees stagnant wages as donors view every dollar spent on workers as less of their money going to the issues they care about. With this, nonprofits are forced to run on skeleton crews who are overworked and overextended, which hinders their ability to attract and retain top talent and perform at peak capacity.

THE RISK IN TAKING RISK

In addition to needing to invest in their people, technology, and operations to be the best they can be, nonprofits also need to be able to take greater fundraising risks. Not every risk will indeed pay off, and a nonprofit is likely always to remain more conservative than a for-profit, but currently nonprofits are not afforded any room for risktaking. Donors need to see instant results and spending the necessary time to build a brand-new fundraising program could be disastrous in the current environment. If for-profits were treated the same, we would never have seen what we know today as Amazon, for example, which for years and years saw losses as the infrastructure was created to support the company that now dominates the global market.

Illustration B

Duszczak, Richard. Cartoon Studio, https://www.cartoonstudio.co.uk/. Accessed 31 Oct. 2022.

As the comic in Illustration B clarifies, if you want to save the pandas, you cannot just drop a ton of money and call it a day. This mission can only be realized if the nonprofit is afforded the ability to spend on overhead to create the infrastructure to make it a reality.

IS THE OVERHEAD STIGMA BEING DISMANTLED?

Many donors still believe that high overhead means an inefficient nonprofit. A study done in 2018 sought to provide hard data on how incorrect this is, and that the current way of thinking about nonprofit donations is fundamentally flawed. The study compared the overhead ratio to two other efficiency measures not traditionally used by nonprofits: data envelopment analysis (DEA) and stochastic frontier analysis (SFA).

These two efficiency measures, while not necessarily suitable for the average donor, were chosen as they can adequately measure overhead and program expenses and the outcomes of a nonprofit compared to the overhead ratio, which only looks at overhead and program expenses. The study partnered with Habitat for Humanity and used their financial and operational data to measure the efficiencies of their hundreds of affiliates. The study found that despite DEA and SFA being two very different approaches to measuring resource spending and outcomes, they were significantly and highly correlated. Essentially, affiliates who ranked high on one of these measures were also ranked high on the other. However, the overhead ratio was typically negatively correlated with the outcome-inclusive measures.

In the study, the top-ranking affiliate under the SFA measure ranked #43 for DEA. However, as its overhead ratio was 32%, it ranked #676 according to the overhead ratio. The top-ranking affiliate under DEA was ranked #2 by SFA but was ranked #713 according to the overhead ratio due to its rate of 36%. This study provided the hard facts to show that the overhead myth does not just destroy an organization’s infrastructure, but that using it as a measure of efficiency is inaccurate. Nonprofits that would be considered inefficient according to general donor thinking are the most efficient when considering their outcomes.

Correcting this problem will take education. Many organizations, including charity watchdogs, have begun attempting to educate donors and the general populace against this line of thinking on overhead. An alternative needs to be established and accepted by nonprofits and donors that moves away from using overhead as a measure and instead focuses more on outcomes and impact. This is no easy feat. How do you compare a soup kitchen serving meals to an issue-based organization to a social service organization providing counseling? The overhead ratio was quick and easily understood. However, the alternative may not be so straightforward. The charity watchdogs and larger foundations are making headway in providing measurable impact to donors.

OUR RECOMMENDATIONS TO MAKE PERCEPTIONS CHANGE FASTER

1. Functional allocation time study: Employees in nonprofits are often wearing multiple hats. A time study can help nonprofits better allocate the employees’ time between the program and overhead. The organization and funders must accurately understand the actual costs between the program and overhead as we move forward from the overhead myth.
2. Review internal policies: Ensure internal policies are up to date with current societal trends so the nonprofit can most accurately reflect its work in the current environment.
3. Educate the Board of Directors: Everyone within the organization must be on board with the change to a more impact-driven organization. As board members typically come from outside the nonprofit community, educating them on trends and myths within the sector is essential. Hence, they understand what is best for the organization.
4. Focus on mission impact: Nonprofits should strive to become better storytellers so they can best tell their organization’s message about the effects of their programs. Telling a better story can help move away from the spending details.
5. Introduce better metrics to show the impact: Nonprofits should stop highlighting their program and overhead ratios and replace them with stories on mission impact.
6. Educate funders and set realistic expectations: Nonprofits should be upfront with funders about the funds it will take to implement or run a program. Proposals should be submitted asking to cover all the expenses necessary to run a program.

Adam Holzberg, CPA, MBA is a Partner at Sax and specializes in audits, accounting and advisory services for closely held companies and non-profit organizations. He focuses on increasing the overall operational efficiencies, financial reporting best practices, and internal controls for clients. He can be reached at [email protected].