It's a fact that people donating to charity increasingly want to know that their donations are making a difference and that the organizations they donate to are spending their money well. Donors want to be sure that they are investing in charities that are deserving of support.
While donors are drawn to causes that resonate with them and generally appreciate the vital importance of the nonprofit sector, a common measuring stick they use to evaluate the effectiveness of an organization (or to compare two organizations) is that of “overhead” or administrative and fundraising costs. In fact, donors and potential donors are expressing significant unease on this topic:
These concerns were spelled out bluntly in MoneySense magazine’s 2015 annual rating: “...Let’s face it, most of us would prefer our hard-earned dollars go to charities that concentrate on their cause, rather than bloated institutions that soak up donations to support their own operation.” While the donor desire for investing in solidly managed charities is one shared by charities themselves, Imagine Canada observes that a focus on overhead is an indication that the nonprofit sector is not well understood and that evaluation of the sector is based on the wrong metrics.
With that in mind, we've created a primer to help charities and their donors understand more about overhead, as well as to explore how donor perceptions about overhead affect the work of charities and consider other useful ways of assessing organizations.
What is overhead?
Lawyer Mark Blumberg defines overhead as "the ongoing expenses of a charity that cannot be directly attributed to any specific charitable activity, but may still be necessary for the charity to function.”
Imagine Canada’s recent Narrative Core Tool Kit, which was developed to broaden the conversation about overhead, notes that "we do not operate in a different universe than governments and business — one in which hard costs such as rent and wages do not exist" and their list of overhead costs include: “ensuring good management, including financial systems, insurance, IT, recruitment of staff/volunteers, governance and communications with stakeholders; everyday essential items such as rent, electricity, hardware, software, salaries, travel, etc.; being transparent and accountable, including the production of annual reports, financial statements and audits, program evaluations and complying with relevant legislation; and, providing a safe environment for participants and beneficiaries, such as screening staff and volunteers who fulfill direct-service roles.”
In 2013, the US-based Charity Defense Council began a series of ads that put a real human face on overhead. One such ad featured the photograph of a young man and read, “I manage the fundraising campaign for the Breast Cancer Alliance. My job is to get more people to give that our researchers can do more to find a cure. My salary gets labeled as ‘overhead’ as if the work I do doesn’t go to the cause. But without the work I do and the money I raise, there is no cause...I am overhead.”
What is the law in Canada?
Before 2010, charities in Canada had to spend on charitable activities at least 80% of the amount of the receipts issued in the previous year. The 2010 federal budget eliminated the 80/20 requirement. Since then, charities have only had to only spend the average of 3.5% of their assets not used in charitable or administrative activities (i.e. if a foundation had $1M in investments it would have to only spend $35,000 per year on charitable activities). Charities are regulated federally by the Canada Revenue Agency and are required to complete an annual T3010 form which monitors their fundraising.
What is the overhead myth?
In an open letter to nonprofits from the three leading sources of information for US charities, the overhead myth is defined as “the false conception that financial ratios are a proxy for overall nonprofit performance.”
Few people within the sector would argue that overhead is a useless measurement — in an similar letter to donors in 2013, the same leading sources for US charities wrote, “That is not to say that overhead has no role in ensuring charity accountability. At the extremes the overhead ratio can offer insight: it can be a valid data point for rooting out fraud and poor financial management.” But, as Blumberg says, “It would be nice if you could work out one ratio to decide whether a charity is good or bad, but you wouldn’t pick a stock based on one ratio, and in the charitable sector (which is often more complicated than the business sector), it’s not appropriate either.”
Blumberg tells of a presenter who asked an audience whether they would support a charity that spent 25% on overhead or one in the same sector and city that spent 10%. “Almost everyone raised their hand to support Charity “B”. The next slide from the presenter contained more information on charities “A” and “B”, and how the low overhead charity was not nearly as effective, had no reserves, had low staff morale, was in financial trouble and was considering its options for merger or being wound up. Now which charity are you going to support?”
Still, Blumberg acknowledges that a charity's spending on overhead shouldn't be completely ignored: “Evaluating a charity simply based on overhead is a terrible way to make a decision — but it isn’t completely irrelevant either.” While examining administrative and fundraising costs can be one measure of determining a fraudulent or poorly run charity, Blumberg suggests that the numbers themselves can be misleading. “The biggest problem with relying on overhead is that the numbers are very unreliable. Most charities are run by well-meaning volunteers. They often do not properly understand the distinction between administration and charitable activities...This, more than any other factor, can account for the differences in overhead numbers.” He adds that overhead numbers can also be manipulated by those operating tax-shelter schemes: “A group that claims to be very efficient, spending 95% on charitable activities, and is being lauded by the media, may in fact only be spending less than 1% on charitable activities.”
Fundraisers in the nonprofit sector find this myth particularly frustrating. Kristy Rempel, donor services manager for the Saskatoon Community Foundation says, “I’m not sure I’ve heard anyone question how much a cancer researcher is making like they do with a fundraiser’s salary. There is a duality, and we as a society have chosen not to care about some things more than others. Further, there is an emotional connection to donated money that isn’t the same as buying a widget from WalMart. We recognize that we can’t have that widget without the manufacturing business that made it but we don’t do that with charities.”
Vu Le, a blogger and executive director of Rainier Valley Corps believes there’s something more philosophical at work behind this myth: “Donors often equate people doing charitable work with the people being helped. We have a myth of the welfare queen, the recipient who is a parasite on society, and we impose this on the nonprofit sector, believing that the sector is filled with people trying to get vacations and fancy cars at the expense of helping people. Because of the power structure between donors and nonprofits, this myth gets perpetuated and funders keep believing it.”
What is the nonprofit starvation cycle?
The nonprofit starvation cycle, a term coined by the Stanford Social Innovation Review after a five-year research project of nonprofit overhead costs, is a direct result of the overhead myth.
The cycle begins with funders’ unrealistically undervaluing what it costs to operate a nonprofit, and is fueled by nonprofits then feeling pressured to conform to those expectations. As the Review states, “At the third step, nonprofits respond to this pressure in two ways: They spend too little on overhead, and they underreport their expenditures on tax forms and in fundraising materials. This underspending and underreporting in turn perpetuates funders’ unrealistic expectations. Over time, funders expect grantees to do more and more with less and less — a cycle that slowly starves nonprofits.”
Researcher and fundraising expert Penelope Burk tells a story that illustrates this pattern. In her first executive director role, Burk’s office received afternoon sun that heated the room like a furnace - the windows didn't open and at one point she measured the temperature at 29 degrees. After Burk ordered custom blinds to make the room comfortable, the treasurer of the organization blew up and the matter became the subject of a lengthy debate at a board meeting. Burk was told that her actions were unacceptable — “after all, we’re a charity!” She says, “The lesson I learned, though, had nothing to do with frugality, and everything to do with denial based solely on the fact that I worked in the not-for-profit sector.”
Should charities spend more on overhead?
Lawyer Alexandra Tzannidakis says, “Spending money on a solid administrative structure can be vital to the success of a charity’s efforts. Indeed, the demonization of overhead costs has led to a situation where many charities are really under-spending in that area and doing themselves, their beneficiaries, and their donors a disservice in the process.”
Imagine Canada’s Narrative Tool Kit cites a 2004 study [The Nonprofit Fundraising and Administrative Cost Project, Indiana University, 2004] that found that “nonprofits that spend too little on infrastructure have more limited effectiveness than those that spend more reasonably.”
Blumberg agrees. “Some charities may be able to have overhead of 10%-15%, but many will quite legitimately have higher overhead expenses, including administration and fundraising, more likely in the range of 20%-35%. You need to look closely at the individual charity, how it is operating and what it is spending money on. It may be that a charity with 20% overhead should be spending 25% while another charity with 15% overhead probably should be at 10%.”
Tzannidakis further notes that, “The emotional nature of charitable giving can perhaps blind people to the reality that charities are still very much businesses – as they must, and should, be. The difference is essentially in their goal: they have donors who want program results, instead of shareholders who want profit results. But just because the destination of the money generated is different, it doesn’t mean the internal mechanisms for generating it are necessarily different. Like any for-profit business, the administrative costs of a charity can be crucial to maximizing its output.”
The nature of the work of the charitable sector can also increase its overhead costs. Le observes that unlike a scaleable business, often “as nonprofits become more successful, our liabilities and instability actually increase.”
Another factor that impacts overhead in the charitable sector can be seen in what the Harvard Business Review’s blog in 2013 recognized as the sector’s “massive talent shortage”, saying that, “To achieve impact, it's critical that social entrepreneurs attract, retain, and develop skilled talent. Competing directly with the private sector to do so is not only a good idea; it's a necessity for the best organizations to succeed.”
How do some organizations keep overhead costs so low, then?
Regardless of how well or badly a charity is run, many distinct factors greatly affect how much overhead is involved in its operations. These factors can include location, nature of operations (i.e. whether a charity does the work themselves or funnels money to other organizations), size, longevity, etc.
Blumberg notes that some types of organizations claim to have little or no overhead costs – such as those drawn from small ethnic or religious groups, those run entirely by volunteers in a small community, or those corporate foundations that assume all administrative costs from their corporation — but cautions against believing these are better charities. “What happens if that company gets bought out by a US-based firm that won’t support the foundation?” CRA also discourages organizations from claiming that 100% of money raised goes to the cause and none is spent on administration because it paints an inaccurate picture of how the organization and the sector actually functions.
What about the bad apples?
Unfortunately there are charity scams out there and they do hurt the individuals they claim to help, as well as damaging the reputations of legitimate charities and the trust of donors and potential donors.
Beyond legal and government requirements, there is a fair bit of information available for donors to access. Information gathered by the Canada Revenue Agency is publicly accessible on the CRA website and is also available on Imagine Canada’s CharityFocus website. There are also a number of codes governing behaviour in the sector, such as Imagine Canada’s Ethical Code Program and the Association of Fundraising Professionals’ Code of Ethical Principles and Standards. Many organizations require accreditation and are subject to ongoing inspection, such as health care or seniors’ facilities. Imagine Canada’s Standards Program also provides greater transparency and accountability.
The previously mentioned open letter to charities advises charities with integrity to:
- “Demonstrate ethical practice and share data about your performance. Proactively demonstrate why donors should trust you. Have the courage to share information about your goals, strategies, management systems, and governance processes.”
- “Manage towards results and understand your true costs...Organizations need to employ effective performance management systems and recognize that financial management is not just about audits...it is also about understanding the cost of achieving their missions.”
- “Help educate funders (individuals, foundations, corporations, and government) on the real cost of results. Have honest conversations with your funders about what it takes to do your work.”
How should donors measure effectiveness?
Tzannidakis advises, “The question should not be how much an organization is spending on overhead, but whether its output metrics show that its internal expenses are efficient at producing program results...The takeaway here is not that more overhead directly equals better programs, but rather that the overhead ratio is not a useful or informative measure of a charity’s worthiness when considered alone.”
Imagine Canada summarizes the best measure of effectiveness by saying, “Rather than focusing on an organization's overhead expenses, the real measure is impact.”
On his website, Blumberg lists 28 important factors a potential donor can take into consideration when choosing a good charity to support.
“Unfortunately,” Blumberg concludes, “despite what some people say, there is no easy way to determine what is an efficient and effective charity. Instead of fixating on ratios, I often suggest people pick one or two organizations that you care about and help them by volunteering. There is nothing like volunteering to see whether a charity is effective and actually making a real difference in people’s lives.”
Susan Fish is a writer/editor at Storywell, a company that helps individuals and organizations tell their story well. She has written for the nonprofit sector for almost two decades and loves a good story.
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