Do you consider yourself a fairly charitable person? If so, here’s some bad news: Everything you think you know about what it financially takes to run a nonprofit is probably wrong. Because of that, you’re probably hurting the groups whose missions you claim to support. [A recent survey] shows most people still believe … that groups keeping operational or indirect organizational costs low are somehow more effective at accomplishing their missions. B. Paynter. “Donors Can’t Stop Believing That Nonprofits Pay Too Much Overhead.” Fast Company (2/8/2018).
The nonprofit sector is being suffocated by a morality imposed from the outside and reinforced from within. It is based on methods instead of outcomes, and it is killing people. I don’t believe there is any cause more important than the eradication of this thinking, because it stands in the way of eradicating many of the great problems confronting humanity. D. Pallotta. Uncharitable: How Restraints on Nonprofits Undermine Their Potential (Tufts University Press: 2013).
A traditional view about what makes a good nonprofit used to go something like this:
the best charitable nonprofits were those that spent the least on indirect costs – that is, costs for such things as accounting, information technology, human resources, training, governance, and management. The same thinking has rarely been applied to for-profit businesses, where such expenses are accepted as essential for creating more efficient and more effective organizations that produce better outcomes. Yet public policies and community attitudes have historically believed that if nonprofit organizations incurred any similar costs, then they were somehow inappropriately diverting resources from direct service delivery. National Council of Nonprofits (2013).
In 2013, following ten years of studies and other works that called traditional thinking into question, charity watchdogs did a 180, dubbing it “the overhead myth” and declaring that “the percent of charity expenses that go to … overhead … is a poor measure of a charity’s performance.” GuideStar, et. al. Letter to the Donors of America (2013). Many in the philanthropic and government sectors have since revised their grant-making practices to loosen the restraints on funding for indirect costs available to their nonprofit grantees.
But not everyone has changed course, a result that can be tragic for small nonprofits. In this post, therefore, we’ll look at how the myth evolved, how it hurts nonprofits, and what nonprofits and funders alike can do to dispel it.
1. THE nonprofit OVERHEAD MYTH AND ITS ORIGIN
We’ve all heard this question: “What percentage of my donation goes to the cause?” In a 2013 manifesto entitled, Uncharitable: How Restraints on Nonprofits Undermine Their Potential, Dan Pallotta underscores its staggering power:
This is the question we have been trained to ask. We do not even think to ask a different question. We wouldn’t begin to know what other questions are available to us. Similarly, we have been taught that the answer to this question is the absolute measure of the real charity being done. D. Pollatta, Uncharitable, p. 128
Why is the myth so pervasive? One reason is that most nonprofits don’t have good ways of measuring and communicating their impact. Although it tells only a very minor part of a nonprofit’s story, the pie chart of overhead versus programmatic costs is an easy-to-produce and easy-to-understand depiction of nonprofit information that has become prolific.
According to Dan Pallotta, a second reason for the pervasiveness of the myth has to do with the fact that it is based on a flawed ideology with roots in early-American religious ideology, namely the Puritan belief in human depravity. He lays out its principle tenets as follows:
- People who want to work in the nonprofit world should be more interested in the good they can do than in the money they can make. Those who want material abundance do not have the concerns of the needy at the forefront of their minds.
- Charities should not take risks. They are taking risks with earmarked funds. They should be cautious.
- Charities do not have the luxury to think about the future. Donated money should be spent immediately to alleviate the suffering of others.
- Charities should not waste money on expensive advertising. It is money that could otherwise go to the needy.
- Charities should not make mistakes. A mistake means a charity is wasting money and waste is immoral.
- No one should seek to earn a profit in charity. Profitmaking is for the for- profit sector.
- Charities should maintain a low overhead percentage. This is the only way to know that any good is being done. Low overhead is moral. High overhead is immoral. D.Pallotta (2013), p. 6.
Pallotta provides detailed, historical evidence supporting his take on the foregoing, which he dubs the “nonprofit ideology” and the ways in which it has been ingrained in our culture. He describes it as “a dysfunctional mentality based on deprivation” and suggests that “[o]ur loyalty to it keeps us from getting what we are really after,” an idea we shall examine further in the next section. D. Pallotta (2013), p. 6.
2. HOW THE nonprofit OVERHEAD MYTH HURTS organizations
Nonprofits that limit spending on overhead in service to the idea that the best organizations are those with the lowest overhead ratios are shooting themselves in the foot. To solve huge problems they need to be able to hire talented staff members and rally others to the cause through investments in marketing and fundraising, actions that contradict the myth. As Pallotta notes:
Social problems are massive in scale, our organizations are tiny up against them, and we have a belief system that keeps them tiny. We have two rulebooks. We have one for the nonprofit sector, and one for the rest of the economic world. It’s an apartheid, and it discriminates against the nonprofit sector. D. Palotta (2013).
As the nonprofit watchdog, GuideStar notes, “[e]valuating nonprofits by how much they spend – or don’t spend – on overhead weakens nonprofits by forcing them to forego investing in themselves.” GuideStar. Six Tips for Busting the Overhead Myth, p. 6.
It is a demise akin to death by a thousand cuts, given the hoops that most nonprofits jump through to categorize as many expenditures as possible as programmatic rather than as overhead costs:
Nonprofits spend far too many resources attempting to report their functional expenses honestly. Costly time studies and complicated time sheets are used to determine how many hours each staff member spends on programs. Organizations build and maintain complicated accounting structures so every expense can be reported by function. A simple phone bill is recorded in the books as a lengthy journal entry of functional allocations, with back-up detail for the auditor to test at the end of the year. To what end?
The reporting of functional expenses exacerbates the myth that, somehow, nonprofits should be able to operate programs without an administrative structure to manage, measure, and execute. It implies that, by some as-yet-unknown magic, nonprofits should be able to achieve their mission without dedicated and systematic fundraising efforts to pay for it. The attempt to segregate interwoven and complementary expenses according to the function they serve is an exercise in futility. The truth is, all resources spent by a nonprofit are spent in order to successfully deliver on programs (with obvious exceptions made in cases of fraud). Certainly, not all spending in a nonprofit is efficient; but functional expenses tell us nothing about efficiency. C. Knowlton, Why Funding Overhead is Not the Real Issue: The Case to Cover Full Costs (2016)
And it ultimately means that service delivery and the viability of the nonprofit sector are comprised. A 2004 study by the Urban Institute’s Center on Nonprofits and Philanthropy and Indiana University’s Center on Philanthropy laid a lot of blame at the foot of public funders, noting that “nonprofits with the weakest organizational infrastructures relied on the public sector for half or more of their revenue, and the public sector practice of providing little support for overhead costs was directly related to the existence of those weaknesses.” National Council of Nonprofits (2013). A 2010 study by the federal Government Accountability Office (GAO) noted that:
actions to underfund nonprofit indirect costs “potentially limit the sector’s ability to effectively partner with the federal government, can lead to nonprofits providing fewer or lower-quality federal services, and, over the long term, could risk the viability of the sector.” This underfunding gap creates an ongoing danger to the long-term economic viability of the nonprofit sector, threatening the government’s main partner in delivering services to people in local communities. Indeed, the replacement costs to governments – that is, how much it would cost taxpayers for governments to try to replicate the work of nonprofits – would likely be exorbitant. GAO. “Treatment and Reimbursement of Indirect Costs.” (2010)
A 2016 article in the Nonprofit Quarterly alluded to the cycle of doom that results when overhead is underfunded:
C. Knowlton (2016). The Stanford Social Innovation Review has called this “doom loop” the “Nonprofit Starvation Cycle,” because it starves charities of the freedom they need to best serve the people and communities they have targeted. A.Gregory & D. Howard. The Nonprofit Starvation Cycle (2009). In their 2013 “Letter to the Donors of America,” signaling a shift in thinking about overhead as a measure of nonprofit performance, GuideStar, Charity Navigator and the BBB Wise Giving Alliance underscore its negative impact on communities, noting that “[t]he people and communities served by charities don’t need low overhead, they need high performance.” Letter to the Donors of America (2013). A nonprofit leader summarized the challenge this way:
The irony for the field as a whole is that a technique meant to control costs actually undermines efficiency and program quality. The inability of nonprofits to invest in more efficient management systems, higher skilled managers, training, and program development over time means that as promising programs grow, they are hollowed out, resulting in burned out staff, under-maintained buildings, out of date services, and many other symptoms of inadequately funded “overhead.” National Council of Nonprofits, 2013.
And author Dan Pallotta opined as follows:
We are taught to feel good or bad on the basis of things that don’t make an impact or that unexpectedly make a negative impact, like modest executive salaries, donated equipment, donated advertising, low spending on administration and “overhead,” instead of on the basis of the real moral questions, like whether hunger is being ended or cancer is being cured. We have been taught to judge morality by tactics without regard for the morality of the outcomes. D. Pallotta (2013), p. 8.
. . .
Efficiency measures prevent charities from investing adequately in infrastructure, discourage them from hiring the talent they need, penalize them for courage and reward them for timidity, prevent them from pursuing long-term vision, discourage them from investing in advertising to build demand, and, if given the chance, penalize them for paying a return on investment capital. In all these ways, they methodically institutionalize the very suffering we want to eradicate. D. Pallotta (2013), p. 169
3. DEBUNKING THE nonprofit OVERHEAD MYTH
A. Strategies for Nonprofits
There are several strategies that nonprofits can pursue to help debunk the overhead myth:
(1) Show Donors Your Unique Value
This strategy involves helping donors differentiate your nonprofit from over one million others that currently exist in the U.S. The idea is to use your marketing channels to convey what makes you unique in terms of the services you provide, the location in which you provide them, and/or your track record. GuideStar. Six Tips. (See this post for more information on messaging and this one for creating a marketing plan). GuideStar also suggests updating your GuideStar profile to reflect your unique mission, vision and values.
(2) Demonstrate Ethical Practice
GuideStar says that “nearly half of donors say they are concerned about how nonprofits use their donations.” GuideStar. Six Tips. It counsels nonprofits to create a website impact section containing documents that demonstrate transparency, such as your strategic plan, annual reports, program activities, governing board rosters, financial statements, and IRS 990. Other strategies including regularly informing stakeholders about your financial and programmatic results via your marketing channels and reviewing related resources from the national Council of Nonprofits, the BBB Wise Giving Alliance, and Charity Navigator.
(3) Share Data about Your Performance
Share data about goals, strategies and outcomes using metrics that best fit your organization. Two excellent resources for understanding and identifying metrics include Trying Hard is Not Good Enough, a book by Mark Feldman that is available for purchase on my Resources Page.
(4) Manage Toward Results and Understand Your True Costs
Monitor and report on your chosen metrics, paying particular attention to those that show whether anyone is “better off” as a result of your efforts. Once you are able to accurately measure your results, you should analyze the direct and indirect costs of achieving your mission. GuideStar. Six Tips. Helpful resources include the Performance Imperative website and this graphic re-visioning of nonprofit costs.
(5) Show Your Board and Funders How Spending on Overhead is Making a Difference
Outline expenditures that improve sustainability and better able you to serve your mission. GuideStar. Six Tips. A good resource is a Bridgespan article on the Nonprofit Starvation Cycle, which outlines examples of how robust infrastructure supports organizational success. Also, practice new ways of talking about overhead:
The reality is, most overhead costs are people costs—educated employees who contribute to mission by making sure the organization runs smoothly. Talk about what they do in compelling, specific detail, and how it contributes to mission: “Our counselors do their best work with survivors of domestic violence when they can give each client their full time and attention. That’s why the work of our professional HR team is so important. By attracting and retaining effective staff members, ensuring payroll is accurate and on time, managing benefits, and handling proof of counselor qualifications and required training, our HR team lets counselors spend more time with our clients. This results in more clients served and stronger relationships between clients and counselors.” C. Knowlton (2016).
(6) Educate Funders about the Real Cost of Results
Real or “full” costs include “day-to-day operating expenses (both program and overhead expenses) plus a range of balance sheet costs for short-term and long-term needs.” C. Knowlton (2016). A good formula is as follows:
[Day-to-day operating expenses] + [working capital] + [reserves] + [fixed asset additions] + [debt principal repayment] = FULL COSTS
You should update your communication and fundraising pitches to reflect and ask that these costs be funded. C. Knowlton (2016). A good resource for implementing this step is the Overhead Myth outreach tool kit.
B. Strategies for Funders
As noted above, many philanthropic and government funders are changing their grantmaking strategies in light of solid evidence indicating that the highest performing nonprofits spend more on administrative overhead than their less effective peers. This is because:
Overhead costs include important investments charities make to improve their work: investments in training, planning, evaluation, and internal systems—as well as their efforts to raise money so they can operate their programs. These expenses allow a charity to sustain itself (the way a family has to pay the electric bill) or to improve itself (the way a family might invest in college tuition). Letter to the Donors of America (2013).
“[B]oth nonprofits and funders know that organizations that operate on duct tape and shoestrings are generally not effective at achieving their goals.” GuideStar, Six Tips. The 2013 Letter to America’s Donors argued that “many charities should spend more on overhead” for these reasons. (Ibid).
Strategies suggested for or implemented by funders to debunk the overhead myth include the following:
(1) Exploring New Measures of Nonprofit Performance
The Letter to the Donors of America suggests that funders look at specific alternatives to overhead expenditures as measures of nonprofit performance, including transparency, governance, leadership and results. In his groundbreaking book, Dan Pallotta notes that “no single measure will suffice” and offers this list of alternative measures:
- How effective are the charity’s programs and how is efficacy being measured?
- What is the quality of the organization’s program staff?
- How do the organization’s clients rate its efforts?
- What is the scale of the achievement, and are comparisons being made with achievements of equal scale?
- What is the incremental effect of a donation in the present moment?
- How new is the charity?
- How well known is the cause to the public, and does the charity face greater difficulty than its peers in raising funds?
- How have economic conditions affected the charity?
- Are comparisons being made between charities that account for program expenses in an identical manner?
- Are intangible benefits being accounted for?
- Is the future value being accounted for?
- Is the value of the outcome being accounted for?
- Is the organization attempting any bold initiatives that might affect the dollars going to programs?
- What is the organization’s long-term vision and what is it doing to achieve it?
- How is long-term investment affecting the short-term financial picture?
- Does the organization have adequate infrastructure? D. Pallotta (2013), pp. 170-171.
He argues further that:
Only when we understand that what we need is a rich array of information, produced by human beings as well as calculators, and that it will be neither simple nor inexpensive to obtain, will we be looking in the right direction. We need better measures, we need to measure more important things, we need rich narrative as well as metrics, and we need several billion dollars in resources with which to do it. We must transform our whole conception of what it means to evaluate charity …
Such a conception must look beyond the language of numbers. It must use words. Beyond numbers, there is vision, intention, commitment, and challenge. There are the people who benefit from a charity’s programs, the people who work for the charity, the community in which the charity operates, and the donors and board members that serve it. Their assessment deserves a voice as well. There are the charity’s hopes and dreams and its dedication to them. These are not captured by numbers …
This conception must also move beyond suspicion. It must abandon the image of a “watchdog” and embrace the idea of watching good. It must be motivated by humility, respect, and a spirit of cooperation and mutual education. D. Pallotta (2013), p. 172.
(2) Collectively Studying Institutional and Sector-Wide Barriers to Adopting New Measures of Nonprofit Performance and Embracing Full Costs
A case in point comes from California, where grantmakers undertook a collective study to determine how to better support grantees to achieve the outcomes and impacts they desired in their communities:
Created by funders for funders, the Real Cost Project explored how best to support grantmakers in developing new grantmaking practices based on what it really costs nonprofit organizations to deliver outcomes. Through research, regional convenings, and senior level executive briefings, the project identified what it would take for funders to overcome institutional and sector-wide barriers and to be able to move from awareness to action. The Real Cost Project (2016).
In 2014, following a Government Accounting Office (GAO) Study, the federal government began requiring federal grants to cover nonprofit overhead costs. C. Knowlton (2016). One commentator expressed hope that state and local governments would follow the federal government’s cue:
This shift in thinking on indirect costs is long overdue and worthy of immediate attention by policymakers whose job is to ensure that taxpayer dollars are invested to deliver the greatest impact. Governments at all levels have the opportunity now to reverse outdated policies and practices regarding indirect costs and strengthen the service delivery system within their jurisdictions. National Council of Nonprofits (2013).
That hope bore at least some fruit in 2015 when the L.A. County Board of Supervisors voted to adopt federal guidelines to pay nonprofits full-cost reimbursement. R. Cohen. L.A. County Board of Supervisors Votes to Adopt the OMB Uniform Guidelines (2015).
(3) Providing and Applying Clear and Consistent Definitions of Administrative Costs, Indirect Costs and Overhead
The National Council of Nonprofits has argued that:
The terms administrative costs, indirect costs, and overhead are often used interchangeably and thus inconsistently. The inconsistent understanding and usage of these and other terms in OMB Circular A-122 and IRS Form 990 have contributed to the systematic underfunding of the work of charitable nonprofits, eroding their sustainability – which, as noted by the GAO, threatens government and the public.36 Policymakers can significantly improve compliance and performance by clearly defining each term and codifying these definitions so they are consistent at the federal level and across states and localities. National Council of Nonprofits (2013).
4. Conclusions
One or more stable sources of funding for full costs can be a game changer for a small nonprofit. Use the resources provided here and on my Resources Page to debunk the overhead myth and fuel your growth.
RESOURCES
Cohen, R. “L.A. County Board of Supervisors Votes to Adopt the OMB Uniform Guidelines to Pay Nonprofits Full-Cost Reimbursement.” The Nonprofit Quarterly (11/4/2015) (Available at: https://www.councilofnonprofits.org/article/la-county-board-of-supervisors-votes-adopt-the-omb-uniform-guidelines-pay-nonprofits-full).
Garry, J. "Busting the Overhead Myth." Nonprofits are Messy: The Podcast of Joan Garry (Available at: https://www.joangarry.com/ep-67-busting-the-overhead-myth/).
Government Accounting Office (GAO). “Treatment and Reimbursement of Indirect Costs Vary among Grants, and Depend Significantly on Federal, State, and Local Government Practices” (May 2010) (Available at: http://www.gao.gov/new.items/d10477.pdf)
Gregory & Howard. “The Nonprofit Starvation Cycle.” The Stanford Social Innovation Review (Fall 2009) (Available at: https://ssir.org/articles/entry/the_nonprofit_starvation_cycle).
GuideStar. Six Tips for Busting the Overhead Myth. (Available at: https://trust.guidestar.org/guidestars-6-tips-for-busting-the-overhead-myth).
GuideStar, Charity Navigator & BBB Wise Giving Alliance. Letter to the Donors of America (2013) (Available at: http://s5770.pcdn.co/wp-content/uploads/2013/06/GS_OverheadMyth_Ltr_ONLINE.pdf).
Hopkins, B. How the Overhead Myth Hurts Nonprofits and What Can be Done about It. (Md. Conservation Conference & Symposium, May 16, 2019). (PowerPoint Slides).
Knowlton, C. “Why Funding Overhead is Not the Real Issue: The Case to Cover Full Costs.” The Nonprofit Quarterly (1/25/2016) (Available at: https://nonprofitquarterly.org/2018/09/12/why-funding-overhead-is-not-the-real-issue-the-case-to-cover-full-costs/).
National Council of Nonprofits. Investing for Impact: Indirect Costs Are Essential for Success (September 2013) (Available at: https://www.councilofnonprofits.org/sites/default/files/documents/investing-for-impact.pdf).
Northern California Grantmakers, et. al. The Real Cost Project: Increasing the Impact of Philanthropy in California (2016) (Available at: https://ncg.org/sites/default/files/resources/RCP%20Final%20Report%20Full%20Version%20FINAL_Aug2016.pdf)
Pallota, D. The Way We Think about Charity is Dead Wrong. (Ted Talk, 2013) (Available at: https://www.ted.com/talks/dan_pallotta_the_way_we_think_about_charity_is_dead_wrong?language=en)
Pallotta, D. Uncharitable: How Restraints on Nonprofits Undermine Their Potential (Tufts University Press: 2013) (Available for purchase on my Resources Page).
Paynter, B. “Donors Can’t Stop Believing That Nonprofits Pay Too Much Overhead.” Fast Company (2/8/2018) (Available at: https://www.fastcompany.com/40528257/donors-cant-stop-believing-that-nonprofits-pay-too-much-overhead).