The Truth about Overhead

"Overhead" expenses are a segment of the overall costs of conducting a nonprofit organization's mission. These include the costs of office machinery, rent, the administrative assistant's salary, utilities, office supplies, etc.

The general rule of thumb has been that the lower an organization’s overhead, the better; the logic being that this means the agency directs more of its income toward conducting its programs.

This single piece of data has informed many donors including individuals, foundations, corporations, and government bodies and has created tremendous pressure on nonprofit agencies to keep these costs low. It turns out, however, to be a red herring.

Together, the Center on Philanthropy at Indiana University and the Center on Nonprofits and Philanthropy at the Urban Institute conducted the Nonprofit Overhead Cost Study, which examined the true meaning and role of overhead costs to a nonprofit’s ability to effectively carry out its mission. Its findings rejected the long-held notion that the best nonprofits had the lowest overhead costs. The following is an excerpt from the report “Donating to Charity: a Guide.”[i]

…the overemphasis on low overhead, far from enhancing the efficiency of charitable organizations, has reduced their effectiveness and corrupted their accounting. Let’s talk about effectiveness first. Overhead pays for the organizational infrastructure that supports a program. It’s the rent, electricity, heat, telephone, and furnishings. It’s the management and board. It’s accounting, human resources, and information technology. It’s the website you visited, the annual report you read, and the time of the people who talked to you when you called.

Overhead isn’t waste; it’s the basis for mission effectiveness. The Nonprofit Overhead Cost Project found wide variation in the adequacy of organizational infrastructure. Some charities included in the study had nice facilities, the latest computers and software, and highly experienced and sufficient staffing in supporting functions, such as accounting, information technology, and fundraising. At other charities, rain came through the roof, computers were mismatched hand-me-downs, software was makedo, and key support staff had limited training or experience for their roles, or were part-time because this was all the organization could afford.

These limitations had consequences for the effectiveness of these organizations. The mismatched computers frequently crashed and were expensive to maintain. Weak financial staff and software meant charities didn’t really know where the money was going, and financial controls were often inadequate as well. Poor software meant charities didn’t have good information about what they were accomplishing that they could share with donors and other supporters, or wasted money on fundraising that wasn’t properly targeted. None of the organizations in this study was an extravagant spender on overhead items, and while there are undoubtedly some charities that are, by far the more common problem is spending too little on the organizational infrastructure that is the foundation for effective programs over the long term. Lower is not better—better is better. And by and large, you get what you pay for. (bold added by author)

As donors, we don’t want a large portion of our gifts being spent to raise the next ones. We expect nonprofits to fundraise efficiently. Charity Navigator measures fundraising efficiency by the ratio of fundraising expenses to the total contributions received by the agency. This determines how much the agency spent to raise each donated dollar.

Here again, though, a caveat: there are many who believe that nonprofits would be well-served to act much more like the for-profit corporate sector. Dan Pallotta, author of “Uncharitable: How Restraints on Nonprofits Undermine Their Potential,” made the following comments about our expectations of nonprofit organizations to produce outcomes with few resources:

We let business pay people based on value. But we don’t want people making money in charity. Want to make a million as a CEO selling violent video games to kids? Go for it. Want to make a million curing kids of cancer? You’re a parasite. So our top business schools grads gravitate to the for-profit sector.

We let business advertise until the last dollar no longer produces a penny of value, but we don’t want charitable donations spent on advertising. So charities can’t build demand for causes. Budweiser’s all over the Super Bowl. AIDS and Darfur? Absent.

We let business make mistakes but expect charity to spend contributions cautiously. It’s OK if a $100 million Disney movie flops, but if a $5 million charity walk doesn’t show a 75% profit year one? Call the attorney general. So charities can’t develop learning curves for revenue generation.

Amazon could forego investor returns for six years to build market dominance. But if a charity embarks on a long-term plan with no return for six years – we expect a crucifixion. Business can offer profits to attract investment capital. But there’s no stock market for charity. So the for-profit sector monopolizes the multi-trillion-dollar capital markets. No competitive compensation, no advertising, no risk-taking, no long-term vision and no capital markets. A perfect storm of prohibition that puts the nonprofit sector at extreme disadvantage to the for-profit sector. We blame capitalism for the inequities of society and then refuse to let charity use the tools of capitalism to rectify them.

Maybe capitalism isn’t the problem. Maybe the lack of it is. It’s been banished from charity by a Puritan ethic of deprivation that considers it contaminating. Maybe an ethic that stands in the way of progress is an ethic whose time is done.[i]

[i]. National Public Radio, “Marketplace,” commentary by Dan Pallotta, “Use Capitalism to do Good Works.” December 11, 2008, http://marketplace.publicradio.org/display/web/2008/12/11/pm_post_puritan_philanthropy/

[i]. The Center on Philanthropy at Indiana University, National Center for Charitable Statistics and the Urban Institute, “Donating to Charity: a Guide,” (2004), http://nccsdataweb.urban.org/kbfiles/541/Donor%20Guide.pdf