Why Low Nonprofit Overhead Doesn’t Equal Efficiency

Public perception that overhead for nonprofits is “bad” has been a pervasive problem for decades (made worse by national ratings agencies), primarily based on public attitudes that nonprofit leaders should be paid less than their corporate counterparts because they chose to work in public service roles. The common attitude is that these leaders were drawn to service, and compensation is the opposite of that desire.

Even in democratic states, polls have shown that the majority of survey respondents subscribe to the “vow of poverty” theory when it comes to nonprofit leaders and staff. It’s understandable that donors and funders want their money to go directly to the nonprofit mission rather than things like salaries and benefits. Those things aren’t inspiring.

However, as experienced nonprofit leaders and boards have known for a long time, low overhead does not equal efficiency or health. A new study of this assumption comes to the same conclusion. At North Carolina State University, a study of more than 600 Habitat for Humanity affiliates around the U.S. found that measuring efficiency based on an overhead ratio doesn’t account for how many houses the affiliates were actually producing, that is, the outcomes that donors most want to see.

Nonprofit Overhead Should Account for ‘Full Costs’

In a recent article in Nonprofit Quarterly, a referenced 2015 article by Claire Knowlton hit the truth on the head about the realities of a “low-overhead nonprofit.” It is unsustainable.

She made the case for a new budgeting formula called “full costs.”

Day-to-day operating expenses +
Working capital +
Reserves +
Fixed asset additions +
Debt principal repayment =
Full Costs

Unless a nonprofit has sufficient capital for today and a surplus for future health, the mission is not sustainable, according to Knowlton. Seems reasonable, given that this approach is how for-profit businesses and even family households operate.

The article calls for a new relationship with donors and funders that communicates this reality and transcends the “vow of poverty” myth that leads donors and governments to scrutinize the way a nonprofit is operating rather than its outcomes within a community.

For example, a key point made in the article is that a focus on low overhead often leads nonprofits to the difficult choice of procuring goods and services outside their local communities based on bottom line price rather than community good.

Another example is the inability to attract and retain innovative or experienced talent if salaries and benefits erode at a nonprofit over time in the name of “efficiency.”

Seek Help From Experienced CPAs

This conversation is ongoing, and LvHJ is at the forefront of helping nonprofits communicate the basis for compensation on their Form 990 and other financials in a way that is transparent, but also accurate for the results and leadership that will sustain nonprofits long into the future.

Talk to us about your reporting or budgeting concerns.

Source: Nonprofit Quarterly, “About Nonprofit Waste, Overhead, and Financial Subservience;” Wiley Online Library, “Toward a Valid Approach to Nonprofit Efficiency and Measurement”

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