Overhead - it’s a term heard often in the nonprofit sector, and it’s one that carries with it a certain air of controversy. But for those of us who don’t know the ins and outs of it — what exactly is “overhead,” and why is it important? As a new nonprofit professional with limited personal knowledge on this concept, I wanted to know, in simple, non-complicated terms, what all the fuss is about in regards to overhead. Below is my explanation, non-expert to non-expert.
By definition, overhead refers to the administrative costs necessary for an organization to operate. In the nonprofit sector, as defined by the Form 990, this refers to the amount spent annually on management and general expenses, and fundraising expenses. These include the cost of employees (not working directly on the program), insurance, building maintenance, event planning, and marketing. Essentially, everything aside from the nonprofit’s program costs contribute to the nonprofits’ overhead.
While this may seem pretty straightforward, a great deal of controversy surrounds overhead in the nonprofit sector. The terms “management and general expenses” are often misinterpreted or misunderstood. For example, a nonprofit’s mission is to help single parents find a work-life balance between working a full-time job and also managing a family. They have two employees (the only expense): an executive director and a counselor. The nonprofit may classify the executive director as 100 percent management and general expenses, making their overhead 50 percent. However, in reality, the executive director spends 80 percent of her time working directly with families, and only 20 percent of her time is truly spent on management and general expenses. This means that the true overhead ratio is 20 percent.
In addition, the general belief is that the less money spent on administrative costs or fundraising, the more money there is available for the cause, leading to the public view that overhead is separate from the cause and therefore a negative source of spending. The result is the widespread assumption that low administrative and fundraising costs are desirable.
Unfortunately, this so-called overhead myth has had some less-than-desirable effects on the nonprofit sector. Nonprofits with “high overhead” may face challenges securing grants, donations, government contracts, and even positive ratings by other organizations. To make matters worse, in order to achieve lower overhead costs and avoid potential challenges, many nonprofits underfund necessary overhead costs that would’ve resulted in more long-term financial sturdiness. This can lead to understaffing, poor or absent staff training and education, insufficient insurance, damaged facilities, lower productivity, and obsolete tools and equipment, which all put nonprofits at far greater risk than high overhead.
For example, a nonprofit may decide against having a quarterly roof inspection because the cost of the inspection, as well as any necessary repairs, would drive the overhead cost up. As a result, wear and tear on the roof goes unnoticed and a leak develops during the winter storm season, causing internal water damage. As explained in our recent blog post, this type of preventable incident is not covered by insurance, meaning that the nonprofit would then bear the cost of not only the repairs to the roof, but also any internal water damage. If the nonprofit had done the initial inspection and found and fixed the leak before internal damage occurred, they would’ve spent less on administrative costs than they did in the end, and they would’ve avoided a potential lapse in services caused by the need for internal repairs. As you can see, underinvestment in administrative costs can be far more detrimental than high administrative costs, and significant cuts in spending in these areas can lead to poor organizational performance and a lack of overall sustainability.
Fundraising expenses may also be cut to avoid high overhead so that more money can be available for the cause itself. However, the reality is that investing in fundraisers usually leads to higher gains. In fact, this is one of few areas where a nonprofit has potential room for growth and the ability to multiply the amount actually available for the cause. By investing in fundraisers, nonprofits have to spend more on overhead, yes, but the result is a higher rate of impact.
This brings us to the biggest issue with all of this – the fact that overhead may not be an indication of an organization’s impact. Nonprofits are putting themselves in harm’s way to avoid high overhead, when the reality is that higher than average overhead may be appropriate. Organizations account for costs differently, costs vary by location, and some programs cost more to run than others. Additionally, newer organizations require an investment in infrastructure that larger, more established organizations don’t need. The truth is, so many factors determine how high or low overhead can be, and it can vary so significantly from year-to-year and organization-to-organization, that there’s no way we can say with absolute certainty that nonprofits have less impact when overhead costs surpass a specific amount.
At this point, you may be wondering – what can be done to mitigate the undue negativity surrounding nonprofit overhead? In the last several years, the nonprofit sector has already made several great strides towards change. GuideStar, Charity Navigator, and the Better Business Bureau Wise Giving Alliance have all denounced overhead as an indicator of nonprofit success, and organizations like the California Association of Nonprofits (CalNonprofits) have started their own projects aimed at changing the way the nonprofit sector thinks about overhead. While there’s still a lot to be done to change the belief system surrounding overhead, things are headed in the right direction!
To find out more about nonprofit overhead and to get involved, check out CalNonprofits’ Nonprofit Overhead Project.