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Nonprofit Overhead and its Importance

“How much of your donation goes to program expenses?” Nonprofit organizations are all too familiar with this question and the high stakes involved in its answer.

A key metric that is front and center in the minds of all nonprofit organizations is the program expense ratio. This ratio is primarily measured by how much money an organization spends on programs compared to its total overall expenses. A concern often raised is that program expense can be an imprecise measurement of the impact of an organization.

It is a known fact that donors tend to avoid charities that dedicate a high percentage of expenses to administrative and fundraising costs. This can reduce the number of donations for organizations that have lower program ratios, which can limit their ability to be effective. On the face of it, this seems an understandable position for donors and is one of the primary factors used in nonprofit watchdog groups to “grade” nonprofits. Other key metrics include total fundraising costs, governance policies, and financial reserves. All of these appear to be reasonable metrics, but some would argue that it is missing consideration on the most important metric of all, total impact. The total impact is something that more and more stakeholders in financial statements want to see quantified, but how? Is it total program expense? Is that a truly accurate measurement of the quality of services provided by an organization? At the moment, the program expense ratio is given priority over program expense totals by oversight agencies.

As a result, watchdog organizations would potentially rank a nonprofit organization that is providing $10,000 of program services and has 10% total fundraising administration expenses over a nonprofit that is providing $100,000 of program services and has 30% total fundraising and administration expenses. Which is the charity that is doing the most good? Moreover, what is the quality of those program expenses?

Consider this example from Dan Pallotta, author of Uncharitable and Charity Case:

As for making donations “go as far as possible,” consider two soup kitchens. Soup kitchen A reports that 90% of every donation goes to the cause. Soup Kitchen B reports 70%. You should donate to A, right? No-brainer. Unless you actually visited the two and found that the so-called more “efficient” Soup Kitchen A serves rancid soup in a dilapidated building with an unpleasant staff and is closed half the time, while Soup Kitchen B is open 24/7, and has a super-friendly staff that serves nutritious soup in a state-of-the-art facility. Now which looks better? The administration program ratio would have failed you completely. It betrays your trust. Itʼs utterly deficient in data about which soup kitchen is better at serving soup. It undermines your compassion and insults your contribution. And yet, we praise it as a yardstick of morality and trustworthiness. Itʼs the exact opposite.

Perhaps recognizing that the primary nonprofit oversight agencies were over-emphasizing overhead, the heads of the Better Business Bureau Wise Giving Alliance, Guidestar, and Charity Navigator (the big three watchdogs) put out a joint letter in 2013 urging the donors of America to look beyond overhead in evaluating where to make their donations.

However, despite examples like the above and outreach from the watchdog agencies, there is no denying that program efficiency is a primary factor of consideration for donors. This may simply be due to human psychology rather than over-reliance on any flawed watchdog agency. A recent study in Science magazine titled “Avoiding Overhead Aversion in Charity” examined the science behind how we, the public, give to charity. In the report, the researchers performed a field study (real people in the real world) and found that having an organization’s ‘overhead’ costs covered by other sources almost tripled the total funds raised when compared to a standard ‘ask’ from the same organization. The ‘overhead’ covered appeal also outperformed asks with seed funding (by 75%) and matching funds (by 90%).

This leads one to the conclusion that the “feeling” of a donor is more important than any rational assessment of how much good their donation would do. The fact that an amount was 100% going “to the cause” was more important to a donor than actually giving a larger amount “to the cause” (when considering the matching funds) would lead to the conclusion that human emotion in charitable giving decisions is the most powerful force at play. As a result, nonprofits need to ensure their requests for donations are hitting the right emotional notes.

The American Institute of Certified Public Accountants (AICPA) knows that watchdog agencies evaluate key ratios, such as the ratio of program expenses to total expenses. This ratio is also used by donors, foundations, financial institutions, and other important constituencies. The higher the percentage of program expenses to total expenses, the better. Some watchdog agencies would find a program expense ratio below 65 or 75 percent to be unsatisfactory. Organizations that can support a program expense ratio of 85 or 90 percent can make the claim that 85 cents or 90 cents of every contributed dollar go directly into program services.

These issues around overhead, and the public’s perception of it, continue to impact and cause an evolution in financial reporting and the auditing profession. Accordingly, in April of 2015, the Financial Accounting Standards Board (FASB) released new guidance intended to improve existing standards for financial statement presentation by nonprofit organizations. The new guidance, in part, is an attempt to help organizations tell their stories and convey their impact. Please see our article, “FASB Proposes Changes to Nonprofit Reporting,” which outlines this new guidance. In addition, an AICPA Nonprofit Audit Risk Alert provides guidance for auditors to focus on functional expenses in order to report them correctly. Organizations should be aware of the guidance provided to auditors so they can ensure their policies in this area are appropriate.

The advice guides auditors to:

  • Obtain or update an understanding of the allocation methodology of expenses by functional classification.
  • Consider whether payroll and related costs are a significant part of total expenses and then specifically review the nonprofit’s methodology for allocating payroll and related costs to the functional classifications.
  • Verify the consistent application of the allocation methodology.
  • Verify that the nonprofit has updated its allocation methodology in a timely manner for any changes in its cost structure. Triggering events could include:
    • office space being added or given up;
    • new debt being entered into;
    • a significant new program being started or discontinued; or
    • staff positions being added or removed.
  • Reviewing and testing management’s policies and procedures for allocating costs to the various functional categories that they support, including the allocation of joint costs.
  • Performing an analytical review of functional classifications.
  • Verifying that the nonprofit’s presentation of program services in the statement of activities or notes to the financial statements is appropriate, consistent, and includes the appropriate costs.
  • Verifying that the number of programs reported for program expenses is adequate based on the complexity of the nonprofit and its activities.
  • Verifying that the nonprofit’s presentation of supporting services in the statement of activities or notes to the financial statements is appropriate, consistent, and includes the appropriate categories, such as fund-raising and “management and general.”

In conclusion, because the ratio is scrutinized by charity watchdog groups, the media, and donors, organizations need to ensure they have appropriate and thoughtful controls and policies in place around the reporting of functional expenses. In addition, stakeholders should maintain focus on this evolving area of nonprofit accounting.

For questions or more information, please contact Michael Barloewen at or toll-free at 844.4WINDES (844.494.6337).
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