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Overhead – It isn’t what you might think!

When the first of the big three “charity watchdogs” began operations in 1996 it was generally considered to be a positive step for the maturation of the nonprofit sector.  Unfortunately, the watchdogs had little information on the results of the organizations they wanted to rank so they developed a rating system based on what was available.  The only readily available information at the time was the financial data from the IRS 990 forms.  In the absence of result data each “watchdog” developed financial ratios and then the ratios were used as a way to evaluate and rank the organizations.  One of those ratios was a measure of overhead.

The “watchdog” agencies are much more sophisticated now, but in the mind of the donating public the overhead figure became the gold standard for nonprofit evaluation.  Every fundraiser knows that the single question they are most likely to hear from a prospective donor is, “What is your overhead ratio?” or “What percent of my money will actually go to help ____?”  The assumption became that overhead was bad and therefore the lower the overhead the better the organization.  This has had a huge impact on the nonprofit sector, but the assumption is false.

Overhead is a factor that needs to be considered, but it is not a good indicator of an organization’s effectiveness for a number of reasons.

  • The data used for the overhead calculation comes from the IRS 990 form which is not an audited document.  There are few, if any, consequences for an organization that “stretches” the truth on this form.
  • The overhead figure can be easily manipulated by inflating gift-in-kind values, misreporting fundraising costs as program costs, aggressively allocating fixed costs to program categories, and/or many other accounting tricks.
  • The nonprofit sector is working on some of the most deeply entrenched and difficult problems in our society.  These tasks are expensive so an organization with low overhead may be less rather than more prepared to actually make a difference.
  • Effective organizations require continuous training, adequate salaries, modern infrastructure/technology, and most importantly effective organizations need evaluations.  These costs are all overhead expenses.  Organization that fail to make these investments will not be effective nor sustainable.
  • Organizations working on different problems in different areas require different levels of overhead.  A soup kitchen in NY will require more overhead than a soup kitchen in the mid-west.  An international disaster relief organization will require different levels of overhead than a homeless shelter.  To hold all nonprofits to the same standard ratio is the worst possible kind of apples to oranges comparison.

To their credit, the “watchdog” organizations have now acknowledged that the overhead ratio was being misused.  On June 17, 2013 they signed a joint letter called the Overhead Myth where they tried to clarify the appropriate use of the overhead ratio.  The letter is available here http://overheadmyth.com/letter-to-the-donors-of-america/

Those of us who evaluate nonprofit organizations would love to have a single metric that would accurately measure organization effectiveness.  The overhead ratio isn’t it.