What is nonprofit overhead?
Nonprofit overhead is described as non-program-related expenses. If an organization files an IRS Form 990, the overhead rate is the sum of reported management and general and fundraising divided by total expenses.
Many have previously explained why the concept of nonprofit overhead is highly problematic.[i] As we discussed last month, the idea of nonprofit overhead creates an unhealthy distancing between mission-related activities and the supporting activities that sustain the organization, as if the mission could be fulfilled without an organization driving the effort.
Nonprofit overhead can also be hard to measure. Overhead is not always defined by job title or by job task. Most nonprofit organizations have budgets under $250,000 and a small staff who always work on everything and take on multiple roles. Many activities blur across the lines of programmatic and non-programmatic categories. Most organizations do not have sophisticated cost accounting or strict time tracking procedures in place. Hours spent on overhead tasks are estimated as best as possible.
Yet there is a need to track and report out operational performance metrics and, for now, the overhead rate continues to be used for evaluation:
- Charity Navigator’s Financial Efficiency Performance metrics include ratings based on programmatic, administrative, and fundraising spending. For “general and grantmaking organizations,” a top rating goes to groups with non-program spending under 15%.
- A Donor Mindset Study reported that the average US donor believes, across the board, that nonprofit overhead should not exceed 19%.
- Public and private funders also often set overhead limits, often 10 to 20% of overall spending.
These overhead rate guidelines and limits are applied to nonprofit organizations regardless of many factors that influence operational expenses, such as mission, programs, budget size, geographic location, staffing model, need for research/development, and lifecycle of the organization.
Why are navigators, funders, donors, and the public in general so keen to set nonprofit overhead rates? And why are higher overhead rates considered to be bad?
We suspect that the setting of overhead rates relates to a common but mis-held belief that nonprofit organizations are inherently inefficient and wasteful because they are not influenced by supply, demand, competition, and other market factors in the same way that for-profit businesses are. How many times have we heard the call for nonprofits to act more as businesses?
But if nonprofits really acted more as businesses, there would be room to invest in overhead. In the for-profit sector, overhead rates are understood to vary by industry and absolutely exceed 19%. In one study, small business overhead rates reportedly ranged from 36% (clothing stores) to 73% (child day care services).[ii]
Somehow a higher overhead is acceptable when the goal is to generate profit but not when the goal is to create mission impact – even when the mission is required to combat market failure.
We also think the drive to minimize nonprofit overhead rates implies a lack of trust in nonprofit leadership. The setting of an overhead rate limit is like the setting of an allowance, or a parental guardrail. The implication is that a spending limit is needed because executive directors lack knowledge, skills, and experience and cannot be trusted to develop operational strategies that best serve their organizations without significant guidance.
Given all these pressures and perceptions, it isn’t surprising that nonprofit leaders are primed to reject strategies that could potentially increase overhead, even temporarily. Couple this with the need for greater funding of high quality nonprofit operations and it becomes clear why there is such a strong drive to minimize overhead.
How can we move beyond the drive to minimize nonprofit overhead and allow for more sound operational management and organizational health?
What if instead of focusing on overhead we asked, “how much are we spending on operations and why?” What are the true costs of programs and operations? We’ve seen more than one nonprofit organization, to minimize overhead, not recognize that their business model relied on taking high operational risks, burning out staff, not staying in compliance, or not allocating for a reserve fund. There is a need to measure and communicate nonprofit health more completely and with a mindset that values proactive and long-term strategy, including investments in operations.
What if we trusted nonprofit leaders to be capable of making the right decisions and requests for their organizations, including decisions to invest in overhead? Imagine a relationship where nonprofit leaders are trusted to make the right programmatic decisions and can also be trusted to make the right operational choices. It is exciting to see the emerging body of work around “trust-based philanthropy.” The Trust-Based Philanthropy Project created an initiative to make trust-based practices the norm in philanthropy through peer-to-peer learning and advocacy.
Overall, funders, donors, nonprofit leaders, the public must build support for nonprofit organizations to spend an appropriate amount, not a minimal amount, on the operations needed for effective and impactful programs.
Together, we must move beyond overhead limits and allow for the possibility that higher operational costs are sometimes necessary for long-term stability, compliance, growth, and innovation.
This article is the third in a series, based on conversations between Jackie Cefola and Debra Box about nonprofit shared services and related topics.
Jackie Cefola, principal of Jackie Cefola Consulting, is a trusted advisor to nonprofit leaders who are starting up new collaborations, often related to shared services. Debra Box, principal of In the Box Consulting and former President and CEO of Support KC, where she helped nonprofit organizations to focus on their missions by providing integrated expertise in financial management and support services.
[i] Vu Le, “How the focus on overhead disenfranchises communities of color and fans the flames of injustice;” Curtis Klotz, “A Graphic Re-visioning of Nonprofit Overhead;” Ann Goggins Gregory & Don Howard, “The Nonprofit Starvation Cycle”