How do you judge whether a charity is worth supporting? Do you review the 990, the audit, the website? What are you looking for when you study those documents? If you’re like a lot of donors, the ratio of non-program expenses to total expenses weighs heavily in your judgment about an organization’s performance. That’s the “overhead myth” – the assumption that the overhead ratio is a good indicator of a nonprofit’s performance. It’s a simple calculation and easy to compare across organizations, but is it a fair method of assessing the impact your donation will have in the community? Is it fair for funders to insist that their money be used only for direct program services and still expect a stellar management team with innovative ideas?
If you haven’t read The Overhead Myth letter, please do. It was a collaborative effort of the Better Business Bureau Wise Giving Alliance, GuideStar and Charity Navigator to encourage donors to consider outcome-based metrics rather than an over-simplified financial ratio. As accountants, we’re big fans of financial ratios, but not in isolation. We have to look at multiple ratios and metrics to construct a fair opinion, and we hope donors will do the same when choosing which organizations and causes to fund.
We firmly believe that a well-prepared Form 990 is an excellent tool for potential donors, but not because of one line that shows how much money is spent on administrative and fundraising efforts compared to program expenses. The 990 is a great tool because of the complete picture it provides about how an organization is managed and governed, how program activities are operated and how the organization is accomplishing its mission. It tells a story that no single ratio can convey.
Beyond the fact that an organization shouldn’t be judged on one metric alone, a bigger issue with the overhead ratio is that there’s no standard for the definition of overhead. If you poll a group of donors and nonprofit leaders, you’ll likely get vastly different answers about what constitutes overhead expenses. Should insurance expense be allocated between program and administrative expense? What method is used for the allocation? How does the indirect cost rate affect the functional expense classification between Admin/Program/Fundraising? Without more uniformity, a comparison of overhead ratios across various organizations is useless. High administrative and/or fundraising ratios don’t necessarily mean the organization isn’t spending money wisely – it could mean they just don’t understand how to show the expenses in their financials or the 990. Small organizations often don’t prioritize spending on professionals who can help them effectively think through these accounting concepts, but it’s a Catch-22. They spend all their money on program costs that are directly benefitting their mission and scrimp on administrative expenses… that’s what donors want, right? But they don’t have the right professionals to help them with the operational aspects of keeping a business compliant with rules and regulations, and they end up misrepresenting themselves on the financials or losing their exempt status because they don’t understand the rules. Obviously there is a need for some administrative expenses, and low overhead doesn’t automatically equate to a well-managed organization.
We’re glad to see the Overhead Myth transforming into an Overhead Solution. This year’s letter from the same trio of organizations as last year encourages nonprofits to educate funders about the true cost of programs and focus their attention on outcomes-based management. Does it really matter which nonprofit’s budget is the tightest if the mission isn’t being accomplished? Donors care about how their money is used, which is why they want to see outcomes instead of outputs. They want to know that their money is being used to create real impact, but their funding style hasn’t quite caught up to that mentality. True overhead typically includes compensation for the Executive Director, accounting staff, HR and fundraising team. If these positions can’t be funded properly because all donations are restricted for direct program expenses, these key positions won’t be filled by the best people. We certainly don’t believe that nonprofits need to be run by Fortune 500 executives or pay unreasonably high salaries, but they need to be competitive to get the right people. Nonprofits know this, but are they conveying it to their funders?
We encourage nonprofits to embrace the transparency donors want and talk to them about what your organization really needs. We’ve seen some great information about outcomes-based budgeting that could be a step in the right direction toward understanding the true cost of program impact and sustainability. Nonprofit performance can’t be boiled down to financial ratios because financial value isn’t the point of nonprofits – it’s about achieving your mission while maintaining a sustainable financial model.
