The Overhead Myth

Pat Richter has been affiliated with the Support Center since 2002 in many capacities, including as a volunteer facilitator of workshops, affiliated consultant, C.O.O. interim, and most recently the Interim Director of Consulting. She consults with nonprofits and foundations both large and small. She has worked with a multitude of organizations to complete organizational assessment, including the PSEG Foundation and the Horizon Foundation. 

gray line

Many nonprofits, especially those with operating budgets under $5 million, are starving themselves in terms of infrastructure and capacity.  The pressure to keep ‘overhead’ costs as low as possible to attract and retain donors results in under-investments in crucial areas.  Unfortunately, many donors do not understand how important these investments are to mission effectiveness, and often make their charitable contributions based on the ‘advertised’ percentage of each dollar that goes to direct services. 

Start-up nonprofits and those focused on controversial causes typically have higher than average fundraising expenses, so they are particularly challenged.

What are ‘overhead’ costs?  They are also referred to as indirect costs, administrative costs, shared costs, or fixed costs.  Any two people talking about overhead are likely to be talking about different things.    Overhead costs typically include liability insurance, staff training, computers/software, fundraising staff/consultants, financial management staff, audits, and physical plant maintenance and improvements.

How do ‘raters’ like Charity Watch and Charity Navigator calculate overhead?  They use each organization’s IRS 990 which divides expenses into three functional areas – program services expenses, management and general expenses, and fundraising expenses.  Management and general and fundraising expenses together make up the ‘overhead’ portion of expenses.  There is an unofficial standard that nonprofits should keep their overhead costs at or below 25% of expenses, reinforced by misleading reporting (most nonprofits under-report their overhead on the IRS 990 and in fundraising materials) and unrealistic donor and foundation expectations.

Wonder what overhead costs are in the for-profit sector?  The average overhead rates of twenty-five industries ranges from 13% to 50% with an average in the mid 20s.  In the service industries, none reported average overhead rates below 20%.

The good news is that Guidestar, Charity Navigator, and the Better Business Bureau issued a joint statement denouncing the use of the overhead ratio as the sole measure of nonprofit performance.  We shall see if that has any impact on donor behavior. 

Here are things nonprofits can do to fight back:

  1. If volunteers provide a significant number of hours toward direct services, monetize that value and add it to program services revenue. Include this value in your financials and annual report.  The IRS 990 does not capture the value of volunteer hours (and neither do the watchdogs) which requires your organization to expand on it in the program accomplishments section.
  2. If you have many facilities to maintain, consider breaking out facilities as an expense category in your annual report. Donors understand that a safe and adequate physical plant is essential; they may not understand that you need an IT consultant!
  3. Educate your Board about the results of inadequate overhead investments on mission effectiveness and good management and help them be comfortable with overhead expenses under 30%.
  4. Provide funders with better ways to measure performance than program ratios. A conversation about costs to achieve outcomes can be much more meaningful.

Here’s an example of how changing the story can benefit a nonprofit:

A therapeutic riding program depended on many volunteers performing a range of activities to support each horse and student rider with a disability for 50 lessons each week.  The operating budget was small as they were a start-up, and fundraising costs were high as all their income was from small fees and unrestricted fundraised dollars.  When they calculated the value of their volunteers, they were shocked to learn that it exceeded their annual operating budget!  Once this value was added as revenue their ratios were more in line with donor expectations.  Donors felt they were getting terrific value for their donations as they were ‘leveraged’ with volunteer hours.  By making capacity investments over several years, the therapeutic riding program has quadrupled in size and attracted a wide range of foundations and corporations as supporters.

Our job as nonprofit leaders is to shift the conversation with donors to results and mission effectiveness, and away from artificial and meaningless formulas that encourage dishonesty and starve the sector.

 

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