It's Over My Head

Giving money away is not always easy, and I often struggled with how to know I was donating to a good charity. It seemed like the default answer from donors and other resources focused on overhead, just overhead. The analysis seemed too simple. It did not seem nuanced enough - maybe it was over my head. I needed to educate myself to be effective and learn how to rate nonprofits. Here's what I've learned.

Not all overhead is bad overhead, and not all expenses are overhead. Whether an organization strives to make a profit or has a charitable mission, it costs money to deliver products and services. Without adequate overhead, a nonprofit cannot attract and retain talent, take reasonable risks, or invest in the systems and infrastructure required for growth. Indeed, leaders in private and nonprofit industries should constantly scrutinize overhead and its impact on profit or efficiency, but severely cutting expenses can harm an organization. While I do not advance the argument that donors should not use an overhead ratio to measure a charity's performance, I advise caution and guidance to ensure financial ratios are not the sole measure. It is frustrating to see a prominent donor restrict a gift to a specific program forcing a nonprofit to scramble for unrestricted funding to cover the overhead costs related to fulfilling the conditions of a restricted gift.

For many potential charitable donors, nonprofit overhead is anathema to the concept of charity. Many donors rely solely on overhead to assess a nonprofit's integrity, and prospective donors lean toward contributing to nonprofit organizations with low overhead ratios. Studies show a negative correlation between the nonprofit's overhead and the amounts contributed. Caviola, Faulmüller, Everett, Savulescu, & Kahane, 2014; Gneezy, Keenan, & Gneezy, 2014). This way of thinking has led to a concept referred to as overhead aversion and can harm nonprofits in the long run. A study from Grey Matter Research and Opinions4Good finds that donors believe the charitable sector has a questionable reputation, with over half of donors saying they believe the average nonprofit spends more than a "reasonable" amount on overhead. Often donors believe that a tax-exempt status justifies strict scrutiny of administrative costs and salaries, forcing leaders to underpay talented employees and causing an organization to struggle and starve.

The "overhead myth" argument has fought to move donors differently by arguing that financial ratios force nonprofits to exaggerate low overhead costs to prove their efficiency. A donor cannot measure a nonprofit's impact by its high or low overhead. Although some funders now concede that overhead ratios are poor indicators of an organization's impact, proponents of the "overhead myth" argue that the social sector has not sufficiently advanced or defined what it means for nonprofits to be financially efficient and adaptable. The "overhead myth" suggests that the persistent inclination to over-scrutinize a nonprofit's overhead ignores the actual costs of delivering a nonprofit's mission. Overhead is essential to a nonprofit's ability to advance its mission; low overhead and restricted funding should be the more significant concern.

Demanding low overhead can cause concern because of the possible negative consequences to nonprofits, funders, and the community. Jan Masaoka, CEO of CalNonprofits, an association of nonprofits in California and creator of the Nonprofit Overhead Project, explains the negative impacts. Masaoka says that nonprofits suffer because unreasonably low overhead causes insufficient spending on administrative functions, lack of professional development and staff training, and fewer people served.

The nonprofit is not the only one that suffers. Funders deal with nonprofits lacking the capacity to maintain levels of excellence, manage finances, or document results. Masaoka tells us that funders can lose a strong network of providers in a given field, making it harder to find strong partners. Likewise, our communities suffer when essential human services are unavailable, and individuals are at risk due to lack of services, gaps in quality control, or substandard facilities. Another consequence of ignoring the actual cost of delivering services is that nonprofits find it difficult to attract people for low-paying direct service positions. When funders limit grants and we experience a tight labor market or inflation, nonprofits cannot hire trained employees.

An effective complement to using an overhead ratio asks donors to focus on a nonprofit's impact; the difference it makes, the work it does, and the results it achieves. Seek information about how the nonprofit uses donations. Ensure the nonprofit you are considering is fully transparent with its numbers and operational aspect of its programs. Ask how the nonprofit compares to others focusing on the cause you are interested in. Examine the organization's strategic plan and its sources of revenue. It takes much more than financial ratios to appreciate what it takes to run a nonprofit efficiently and effectively. Moreover, all nonprofits are different, have different needs, and require various staffing and facilities to meet their missions. These differences bear on overhead and program expenses.

Nevertheless, because a charity's financial efficiency is objective, it remains an important measure most donors should not ignore. It also helps to understand how overhead is defined and how it differs from program expenses such as direct and indirect costs. Thus, I do not urge that donors disregard a nonprofit's financial ratios. Instead, please focus less on overhead ratios and more on seeking the information above and learning about the nonprofit's mission, who it serves, and what it takes to grow sustainably. Simply funding one organization over another solely because it limits overhead to 20% and another spends 30% of its budget on overhead is unreliable for identifying a charity's impact. Avoid a knee-jerk reaction that automatically holds a nonprofit to an arbitrary percentage.

Being a great donor is hard work. Your local community foundations are resources to help you with your research. Thousands of nonprofits fill voids in our communities, changing lives every day. They count on our support to make the world a better place. Thank you.