Without accurate data, funders do not know what overhead rates should be. Although for-profit analogies are not perfect for nonprofits, they do provide some context for thinking about how realistic—or not—average overhead rates in the nonprofit sector are. Overhead rates across for-profit industries vary, with the average rate falling around 25 percent of total expenses.
And among service industries— a closer analog to nonprofits—none report average overhead rates below 20 percent. In the absence of clear, accurate data, funders must rely on the numbers their grantees report. But as we will later discuss, these data are riddled with errors. As a result, funders routinely require nonprofits to spend unhealthily small amounts on overhead. For instance, all four of the youth service organizations that we studied were managing government contracts from local, state, and federal sources, and none of the contracts allowed grantees to use more than 15 percent of the grant for indirect expenses which include operations, finances, human resources, and fundraising.
Some foundations allot more money for indirect costs than do government agencies. Yet foundations are quite variable in their indirect cost allowances, with the average ranging from 10 percent to 15 percent of each grant.
These rates hold true even for some of the largest, most influential U. And foundations can be just as rigid with their indirect cost policies as government funders. For example, when one Bridgespan client added up the hours that staff members spent on reporting requirements for a particular government grant, the organization found that it was spending about 31 percent of the value of the grant on its administration. Yet the funder had specified that the nonprofit spend only 13 percent of the grant on indirect costs.
Most funders are aware that their indirect cost rates are indeed too low, finds a recent Grantmakers for Effective Organizations GEO study. In this national survey of grantmaking foundations, only 20 percent of the respondents said that their grants include enough overhead allocation to cover the time that grantees spend on reporting.
Not only do funders and donors have unrealistic expectations, but the nonprofit sector itself also promotes unhealthy overhead levels. In this context, nonprofits are reluctant to break ranks and be honest in their fundraising literature, even if they know that they are fueling unrealistic expectations. They find it difficult to justify spending on infrastructure when nonprofits commonly tout their low overhead costs. This constellation of causes feeds the second stage in the nonprofit starvation cycle: pressure on nonprofits to conform to unrealistic expectations.
This pressure comes from a variety of sources, finds the Nonprofit Overhead Cost Study. The survey found that 36 percent of respondents felt pressure from government agencies, 30 percent felt pressure from donors, and 24 percent felt pressure from foundations. Every aspect of an organization feels the pinch of this culture. In our consulting work with nonprofits, for example, we often see clients who are unable to pay competitive salaries for qualified specialists, and so instead make do with hires who lack the necessary experience or expertise.
Similarly, many organizations that limit their investment in staff training find it difficult to develop a strong pipeline of senior leaders. These deficits can be especially damaging to youth-serving organizations, notes Ben Paul, president and CEO of After-School All-Stars, a Los Angeles-based nonprofit organization that provides after-school and summer camp programs for at-risk youth nationwide.
Meanwhile, without strong tracking systems, nonprofits have a hard time diagnosing which actions truly drive their desired outcomes. Take the case of a well-respected network of youth development programs. Poised for a huge growth spurt, LGON realized that its data systems would be hopelessly inadequate to accommodate more clients. An analysis showed that program staff spent 25 percent of their time collecting data manually. One staff member spent 50 percent of her time typing results into an antiquated Microsoft Access database.
Staff members can become so accustomed to their strained circumstances that they have trouble justifying even much-needed investments in overhead, our interviews revealed. Upon examination of more than , nonprofit organizations, researchers found that more than a third of the organizations reported no fundraising costs whatsoever, while one in eight reported no management and general expenses. Further scrutiny found that 75 percent to 85 percent of these organizations were incorrectly reporting the costs associated with grants.
Our study of the four youth-serving nonprofits likewise reported discrepancies between what nonprofits spent on overhead and what they reported spending. Although they reported overhead rates ranging from 13 percent to 22 percent, their actual overhead rates ranged from 17 percent to 35 percent.
Many factors support this underreporting of nonprofit costs. According to a survey conducted by The Chronicle of Philanthropy in , a majority of nonprofits say that their accountants advised them to report zero in the fundraising section of Form For example, nowhere does the IRS explicitly address how to account for nonprofit marketing and communications.
As a result, many organizations allocate all marketing and communications expenses to programs when, in most cases, these expenses should be reported as administrative or fundraising overhead. Government agencies likewise have varying and ambiguous definitions of indirect costs. There is some good news. Currently, the U. Foundations and government funders must take the lead because they have an enormous power advantage over their grantees.
When funders change their expectations, nonprofits will feel less need to underreport their overhead. They will also feel empowered to invest in infrastructure. The first step that funders should take is to shift their focus from costs to outcomes.
In the nonprofit world, organizations are so diverse that they do not share a common indicator of program effectiveness. Funders must also clearly communicate their program goals to their grantees.
One of our study participants, for instance, worked closely with its major funder to think through this question, and ultimately determined it needed a sizable investment in technology to support its projected growth. The funder agreed that only by making such an investment would the organization be able to track outcomes uniformly and to make program improvements quickly.
And a CompassPoint Nonprofit Services study of nearly 2, nonprofit executives in eight metropolitan areas reveals that receiving general operating support played a major role in reducing burnout and stress among executive directors.
Regardless of the type of support they provide, funders should encourage open, candid discussions with their grantees about what the latter need to be effective.
As a result, their grants are not as flexible as they need to be. The primary hypothesis of the study is supported by this analy- sis—reported average overhead costs have been decreasing over time from The SOI data is not a random sample of Downloaded from nvs. Overhead cost broken down into administrative and fundraising components.
Over the study period, administrative expenses have fallen significantly while fundraising has almost doubled. The category of overhead expenses comprises two sub-categories: administrative expenses and fundraising expenses. Administrative expenses generally refer to opera- tional costs not directly related to programming, such as accounting fees or postage. When these two components are examined individually, the overhead story becomes even more interesting. Administrative expenses fell from Fundraising increased from 1.
So, although reported overhead has only fallen by 2. Increased fundraising expenses are predicted in more competitive markets Thornton, Figure 5 pres- ents these changes graphically. Small, nonprofessional nonprofits are often run by volun- teers who manage operations and put together fundraisers. As a result, these types of nonprofits have very low overhead. As nonprofits professionalize, they invest much Downloaded from nvs. Overhead as a function of nonprofit size.
Once they begin to grow, however, it is possible to achieve economies of scale through consolidations or collaborations and thus, to begin lowering overhead. This pattern appears in the data when overhead is conditioned by nonprofit size see Figure 6 or for a more nuanced view Appendix B. Whereas the SOI files contain a sample of several thousand nonprofits, the Digitized Data contains all of the nonprofits that filed returns from to Figure 6 was made by splitting the , nonprofits in the data set into 50 equal-sized groups that were binned by their total revenue.
Note that the median reported overhead ratio is lower than the mean reported overhead ratio because of the influence of positive outli- ers and the truncation of overhead at zero. In the previous section, we calculate a reduction in reported overhead by 2. One might worry about a change in the composition of the sample driving the results, rather than an actual sec- tor shift in overhead cost structure. For example, we know that very small and very large nonprofits have small overhead ratios, so adding more of these two groups to the Downloaded from nvs.
Changes in median overhead ratios between and These changes are statistically significant. These effects are addressed using organizational size as a control variable in the model, but if there are changes in the sample that affect overhead but are uncorrelated with size it could complicate the interpretation of results.
Many evaluation studies will control for sampling problems using panel methods that follow the same organizations over time, but panel analysis is not appropriate here because nonprofit size will be correlated with time.
Consequently, it would be challenging to parse apart broad sector affects from changes in cost structure that result from maturation. The Digitized Data set provides another control for issues that might arise because of sampling.
The groups from can be matched to a similar sample from , according to organizational size. Because the data set represents the population of reporting nonprofits, sample bias is no longer an issue.
The average reported overhead for each group in can then be com- pared with the average reported overhead for the equivalent group in These results are represented in Figure 7. We see from Figure 7 that there is in fact a downward shift in reported overhead expenditures by nonprofits between and , and this shift is statistically sig- nificant in the region denoted by the arrows.
Note that the changes are smaller than 2. The magnitude of the changes represented here are not as important as establishing the downward trend in a way that eliminates the hypothesis concerning sampling problems driving the results in the previous section. In examining both size and time considerations, it is clear that there has been a downward trend in reported overhead ratios within the nonprofit sector.
When exam- ining overhead, though, it is important to be aware of the larger influence that size has on the nonprofit cost structure. We turn now to a more detailed analysis of the catego- ries of expenses that nonprofits report on the forms to better understand how cost structures have evolved over the past two decades.
Subcomponent Expense Analysis If reported nonprofit overhead has fallen by 2. In this final section of the analysis we examine groups of nonprofit line item expenses that are reported on the IRS forms using the SOI data. Though each line item can be subdivided into program expenses, fundraising, and administrative expenses whose aggregates we analyzed in the previous section , we do not break them apart here. Instead, we are interested in how nonprofits have shifted expenses internally as the sector has changed over time.
By examining the behavior of line item expenses over time, we can see more clearly any evidence of general shifts in cost structures; this sheds light on the behavioral response of nonprofits to competitive pressures.
This measure does not include depreciation because the focus of this article is on the choices and pressures involved in the cycle, whereas deprecia- tion charges represent capital charges from a previous time period.
Figure 8 represents trends in these groups of nonprofit line item expenses as a pro- portion of total expenses. All the sub-figures have the same y-axis scale so that changes can be compared across graphs. The graphs represent median ratios for each year in each subcategory. Changes in nonprofit cost structure over time. Nonprofits are paying executives more while cutting back on staff compensation and professional fees. The trend in reported overhead ratios is present for comparison.
The trends in the cost structure of nonprofits are clear. As a percentage of total expenses, nonprofits are paying their executive management staff more while cutting costs in staff wages and professional fees.
Spending on benefits and operations has not changed dramatically over this period. Interpreting these trends is more subtle, how- ever, as there are several plausible ways that the trends could occur. Officer wages, for example, will increase if executives were getting paid more but similarly if nonprofits designate more of their staff as management. The nonprofit sector is known for having limited opportunity for promotion within organizations because of small size and lengthy tenure of existing executives, so perhaps nonprofits have begun designating Downloaded from nvs.
More likely, it signs higher price tags on top management who are being recruited away from the corporate sector or top managers from other nonprofits who bring with them large professional networks from years of experience in the nonprofit sector. Professional fees, which include accountants, lawyers, and fundraising professionals, have also decreased.
Perhaps these activities have been cut due to reductions in over- head costs as these tend to fall in that category, although some services like legal and accounting tend to be necessary expenditures.
As the nonprofit sector has become increasingly professionalized perhaps more of these activities were brought in-house and would thus show up as staff or management expenses instead of professional fees.
Perhaps nonprofits are better using pro bono services from large law and accounting firms. Many explanations for these cost shifts are plausible, but will require additional research to firmly establish the causes. Discussion Scholars have referred to the existence of a starvation cycle, but their analyses were based primarily on case studies and anecdotal evidence.
In this article, we have empir- ically demonstrated a steady decline in reported overhead expenditures within the non- profit sector. It is consistent across all nonprofit subsectors and most nonprofit size groups except the smallest and very largest. Reported overhead ratios have declined by 2. This decline can be broken down into an increase in fundraising expenses by 1. In addition to looking at the trends in overhead, we examined trends in expenses across line item categories.
We find that nonprofits are paying exec- utives more while cutting staff costs. We were not able to determine whether these cuts resulted from a reduction in staff numbers or whether nonprofit employees are earning less over time. The implications of a nonprofit starvation cycle in the third sector are of significant concern.
Rooney and Frederick find that human services organizations that depended on foundation grants were more likely to report underfunded infrastructure. Donors rely on overhead information in lieu of the information they really desire—performance and impact metrics.
Current conventions have evolved as a result of the influence of modern management theory, not as a result of a meaningful body of evidence that links lower overhead costs to greater nonprofit impact. Quantitative financial management practices are useful in many regards, but man- agement experts have highlighted problems similar to the nonprofit starvation cycle Downloaded from nvs.
Clayton Christensen, a celebrated Harvard business professor, recently described the harmful effects of the reliance on financial ratios in the corporate sector Denning, : There is a pernicious methodology for calculating the internal rate of return on an investment. It causes you to focus on smaller and smaller wins. Why do we do it? The finance people have preached this almost like a gospel to the rest of us is that if you describe profitability by a ratio so that you can compare profitability in different industries.
Christensen argues that these practices have severe long-term consequences for American firms by gradually depleting organizational capacity to make financial ratios look appealing to investors, an argument very similar to the starvation cycle. These effects are analogous to what hap- pens to nonprofits as a result of the starvation cycle; Miller argues that The inability of nonprofits to invest in more efficient management systems, higher skilled managers, training, and program development over time means that as promising pro- grams grow, they are going to be hollowed out, resulting in burned out staff, under- maintained buildings, out of date services, and many other symptoms of inadequately funded overhead.
It is not clear that donors have appropriate expectations about administrative costs. Increased efficiency is a laudable goal, but not at the expense of reduced nonprofit capacity and increased organizational vulnerability. Our contribution in this article is a modest but necessary first step toward a better understanding of the starvation cycle.
We can say with certainty that there has been a downward trend in reported overhead over the past two decades. What we cannot dis- cern from our data is how much of this has resulted from tangible changes in nonprofit behavior allocating more funds toward programs and away from administrative expenses and how much is a result of changes in reporting practices more sophisticated book-keeping or misleading and potentially dishonest reporting.
Our assumption is that the reductions we observe represent some combination of both practices. We also show that administrative investments are in decline while fundraising expenditure ratios rise, and executive salaries increase while nonprofits spend less on staff. Several implications for institutional and governmental policy exist.
First, donor expectations should be aligned with a healthy commitment to overhead that provides the capital necessary for growth and sustainability of healthy nonprofits. Instead of asking, what is the lowest overhead for nonprofit survival, the campaign is pushing donors to ask, what do good outcomes cost? As part of this process, work is needed to understand the appropriate levels of overhead funding for different kinds of non- profits. A simple rule of thumb for all nonprofits is not sufficient.
Resources on best prac- tices could help donors make better grants without worrying about overspending on overhead. Second, nonprofits should work to standardize definitions of overhead and norms of reporting. Reports of zero overhead are misleading and should be dis- couraged to prevent distortions of donor expectation. Third, nonprofit interest groups should be mindful of large government or private donors that cover inade- quate or no overhead costs.
Because overhead is essential for operations, these types of grants and contracts force nonprofits to spend energy raising additional funds for back-office expenses. Forcing nonprofits to split efforts in this way may make them less effective in the long-term. Fourth, making available reputation information on the quality of donor policies and behaviors could help nonprofits be more discerning about the types of funding they accept. Given the ubiquity of overhead measures as a performance metric, the absence of solid research linking low overhead and nonprofit performance should cause some concern.
Thus, it is challenging to isolate the effects of low over- head from other phenomenon. Furthermore, discerning the effects of overhead on per- formance can be tricky because they may emerge only over a long period of time. The field would greatly benefit from solid empirical scholarship that helps firmly establish a relationship between overhead funding and long-term organizational capacity, vul- nerability, the ability to innovate, and between overhead ratios and competitiveness in grant and contract markets.
We hope that this preliminary empirical work will help move the conversation in that direction. Years prior to do not split fundraising into functional categories. The x-axis represents nonprofit size measured by total revenue. The y axis represents reported overhead expenditures. The graph shows that the range of reported overhead ratios the 10th to 90th percen- tiles here varies significantly with nonprofit size.
Relationship Between Nonprofit Size and Overhead 0. Relationship between nonprofit size and overhead. Acknowledgment The authors would like to thank Michael Andrade for his preliminary work on the article as a summer policy intern at the Andrew Young School, in addition to John Zietlow, the participants in the Accountability, Corruptions, and Transparency session at the ARNOVA confer- ence, and the editor and anonymous reviewers at Nonprofit and Voluntary Sector Quarterly.
Even if we were to assume that Bowman is correct and potential funders do not give a great deal of credence to the overhead ratio, it is the persistent belief that they do throughout the sector that is guiding the starvation. Starting in , a major change in the tax form made variables incomparable with previous years. In addition, expenses are used in the denominator for most charity ratings agencies such as Charity Navigator administrative ratio , the Better Business Bureau Wise Giving Alliance program ratio , and Charity Watch charitable purpose ratio.
The analysis omitted 2, organizations that reported negative revenues. The alternative mechanism would be for surviving organizations to change their overhead cost structure without exiting the sample.
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