May/June 2005 Vol. 46, No. 3

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Read Now (a pseudonym) is a nonprofit organization working hard to teach adults to read and write English. Many of the people it serves are immigrants who have never read or written any language, and for whom spoken English is new. Other clients were born in the United States, but never developed adequate reading skills. For those who achieve literacy, doors open to better jobs, participation in civic life and improved potential for their children. Read Now is typical of many small nonprofits working to create a better life for people.

Read Now is typical in other ways as well. Like many nonprofits, it doesn't have enough money for all it tries to accomplish. Mission and program come first, so the organization has to make do in other areas. Supporting the executive director are an administrative director and development director, but the salaries and benefits for those positions are so meager that only recent college graduates with no relevant experience are attracted to them.

Also, Read Now has only a single copy of Quickbooks accounting software, which saves a few hundred dollars, but reduces financial control and slows access to financial information. The development director has no software at all. Having no experience in the field, he doesn't even know that software to support the development function exists. Read Now works out of donated space, using donated furniture so decrepit that the moving company refused to accept the liability of transporting it to Read Now's new offices.

Despite the excessive thrift of its operations, a funder told Read Now that its grant would not be renewed, because its administrative and fundraising expenses were too high. A review by Read Now's staff confirmed that they were reporting a higher percentage of administrative and fundraising costs than peer human service agencies, so they began to explore how they could reduce reported costs. The development director started listing grantwriting time as "program" instead of "fundraising" on weekly timesheets, on the rationale that the money was being raised for programs. The executive director examined all expenses allocated to administration and fundraising, to see if certain categories—or a portion of them—could be reclassified as program expenses.

The story of Read Now is just one of many from the recently completed Nonprofit Overhead Cost Project (http://www.coststudy.org/). This massive study, funded by The Atlantic Philanthropies, Ford Foundation, Charles Stewart Mott Foundation, The David and Lucile Packard Foundation and Rockefeller Brothers Fund, took more than four years to complete. In addition to detailed case studies of organizations such as Read Now, the study included analysis of tens of thousands of Forms 990 filed with the Internal Revenue Service (IRS) and a national survey of more than 1,500 nonprofit organizations. Many of the findings have important implications for foundations. Many nonprofits are sacrificing organizational infrastructure needs to tell foundations what they want to hear about overhead costs.

Widespread Underreporting

The first finding to emerge from the study was the large share of nonprofit organizations that appear to be underreporting their administrative and fundraising costs. For example, 37 percent of 990s filed with the IRS reporting at least $50,000 in direct public contributions also reported zero fundraising and special event costs. In addition, 27 percent classified some or all accounting fees as program expenses, despite the fact that the 990 instructions give accounting fees as an example of what is meant by "management and general expenses." According to the survey, only 25 percent of nonprofits receiving foundation grants properly account for those proposalwriting expenses as fundraising costs. Finally, just 17 percent of nonprofits receiving government grants properly account for those proposalwriting expenses as fundraising costs.

As the story of Read Now suggests, most underreporting nonprofits are not hiding extravagant overhead expenses. In fact, as we shall see, those organizations often don't have what they need to be effective. Instead, they are telling donors and funders what they want to hear about overhead costs. The consequences for foundations are significant. Because most foundation staff and boards base their idea of appropriate overhead on the amounts that nonprofits report spending, they are likely to significantly underinvest in needed organizational infrastructure for their grantees.

Size and Restricted Funding

The Nonprofit Overhead Cost Project examined the adequacy of management and fundraising infrastructure through detailed case studies, finding wide variation. Some had the staff, technology and facilities they needed to be effective. Some, like Read Now, did not.

Nonprofits use a variety of strategies to make inadequate administrative and fundraising dollars go further, but those strategies can compromise organizational effectiveness. Low pay for administrative positions makes it difficult to recruit and retain skilled and experienced staff. Executive directors end up doing the jobs their staff cannot manage. For example, we found that executive directors supported by only junior staff in accounting and development positions were overly involved in preparing financials for board meetings and writing grant proposals.

Also, doing without necessary technology reduces staff productivity and effectiveness. In one example, an advocacy organization missed a major media opportunity because key staff did not have cell phones. In another, old or donated computers increased maintenance costs, downtime and staff frustration at a private school. Other examples involved old or inadequate facilities, which have hidden costs, such as siphoning executives' time and attention. The situations ranged from the CEO who grabbed a push broom during our visit to sweep out the rain coming through the roof to Read Now's executive director, who scrambled to find sturdier donated furniture when the mover refused to take theirs.

Two factors differentiated nonprofits with adequate administrative and fundraising infrastructure from those without: organizational size and share of restricted funding. The weakest infrastructure organizations all had budgets less than $1 million, and the strongest ones all had budgets more than $2 million. Also, 50 percent or more of annual revenue at the weakest organizations consisted of restricted contributions, such as government grants; at the strongest ones, that figure was well under 5 percent.

Foundations should consider those findings when setting policies on the non-program costs they will fund. A large organization with adequate unrestricted income may be able to effectively use a grant that restricts overhead costs to artificially low levels. On the other hand, a similar grant to a small organization lacking sufficient unrestricted income will simply stress the organization further than it already is. A one-sizefits- all policy on coverage of overhead costs does not suit a highly varied sector that has all kinds of funding streams and cost structures.

Beyond Program and Overhead

The Nonprofit Overhead Cost Project also raises questions about the wisdom of distinguishing between program and overhead costs. No nonprofit studied made this distinction in managing the organization—despite generally accepted accounting principles (GAAP) and IRS requirements to do so. To be sure, the nonprofits all watched the percentage closely to ensure they reported acceptable numbers, but they did not find it useful in achieving their mission.

Worse, the classification sometimes led to false economies that reduced mission effectiveness. We have already mentioned the advocacy organization that saved overhead costs by not having cell phones, only to learn the hard way that immediate communication with media representatives was vital to mission effectiveness. Another case concerned a hotline that could not afford to upgrade its phone system—an expense that was considered part of overhead—because of its restricted funding. Without this upgrade, a suicidal caller could get a busy signal, even though some hotline extensions were not busy. It is hard to imagine a better example of sacrificing the mission on the altar of low overhead. As these cases suggest, foundations would be wiser to focus less on what is called "program" and what is called "overhead," and more on whether nonprofit organizations have what they need for mission effectiveness.

Of course, this returns us to the point about restricted funding. Nonprofits whose funding is primarily unrestricted will buy what they need to be effective. Nonprofits whose funding is primarily restricted can only buy what they need if it happens to fit within their funders' restrictions.

Thus far, we have focused on this study's implications for internal foundation decisionmaking. Foundations should revisit and reconsider their policies on providing support for what is normally called overhead. Current policy may be based on artificially low overhead percentages based on underreporting of actual overhead expenses. Current policy may not take into account important factors such as grantee size and percentage of restricted funding. Finally, current policy may wrongly prevent or limit expenditures necessary for a nonprofit's mission because they fall in the overhead category, yet simultaneously ignore needless or wasteful program expenditures that do not fall in this category. By limiting coverage of overhead in these ways, foundations may be limiting their own effectiveness by limiting their grantees' effectiveness.

However, changing internal foundation decisionmaking is just one way foundations could use grant dollars to address these findings. The Nonprofit Overhead Cost Project has significant implications not only for foundations, but also for policymakers, the public and financial professionals. Foundations can promote positive changes that boost the effectiveness of the nonprofit sector as a whole.

Reaching Policymakers

Government is the largest provider of restricted contributions in the United States. In fact, government grants dwarf foundation grantmaking. In theory, each nonprofit negotiates an overhead reimbursement rate with the federal government based on its actual overhead costs and then receives that percentage on all of its federal grants. While this is true for large research universities that receive significant federal research dollars, it is not so for the typical nonprofit. Frequently, the granting agency specifies the percentage that will be allowed for overhead—usually somewhere between zero and eight percent.

Some agencies use a competitive award process in which organizations requesting lower overhead reimbursement are more likely to get grants. Although born of a desire to reward efficiency, such a process leads instead to a race to the bottom, in which funded agencies lack the administrative infrastructure they need to be effective. State, county and municipal funds, whether block-granted from another government entity or raised locally, contain similarly low allowances for overhead and involve similarly competitive funding mechanisms.

Although foundations should reconsider and revise their own policies on funding overhead costs, they may be best able to help the sector by advocating changes in public sector funding practices. Foundations can fund policy research and advocacy related to these issues. Devolution, privatization and other trends have led to increased public funding of the nonprofit sector. However, increased public funding has led to stricter overhead funding policies that have created other impediments for foundations.

Educating the Public

In 2003, nonprofits received about $179 million in contributions from individual donors—about seven times the $26 million they received from foundations (Source: Giving USA.) Unfortunately, many individual donors have unrealistic ideas about nonprofit overhead. Each year during the year-end holidays, the media urges people to channel their donations to low-overhead charities. Fundraising appeals by some nonprofits claim "100 percent goes to charity" or show a pie chart with an unrealistic claim that 4 percent to 5 percent goes to overhead. Charity watchdog websites either rank and rate charities based on overhead spending or urge donors to do so. Actual overhead spending is lower than it needs to be, although it is still higher than the public's idealized view about how much is currently spent.

Worse, individual donations are the unrestricted income charities use to pay for overhead. Because government grants and large project grants from foundations tend to restrict what can be spent for overhead, nonprofits must use unrestricted funds to pay such costs. For most charities, that means individual donations. Individual donors, however, are not told that their donations are being used for overhead, nor would they want them to be used that way.

Scandals at the United Way, American Red Cross and other organizations show us what happens when individual donors perceive that charities have broken faith with them. The nonprofit sector desperately needs to deal with this problem, either by virtually eliminating restricted funding from institutional funders or by crafting a communications strategy that educates donors before they misinterpret what they find out on their own. Foundations are ideally positioned to encourage and support the kind of collaboration needed to address this sector-wide issue.

Financial Professionals

The Nonprofit Overhead Cost Project also suggests that financial professionals have work to do. Whether nonprofit organizations are their employers or clients, financial professionals have a duty to prepare financial information that does not mislead users about the organization's financial condition. Widespread underreporting of overhead costs could not occur without the accounting profession's acquiescence. Of course, the first nonprofit to suddenly report higher overhead costs is likely to be penalized by donors, funders and charity watchdogs. Thus, underreporting needs to be taken on at the sector level.

The study also turned up several cases of high-stakes misunderstandings of needlessly confusing and misleading nonprofit financial information. For example, a food bank found it difficult to raise operating funds from corporate and private foundations because its annual financials showed a surplus of $50,000. The surplus—a capital grant used to purchase two refrigerated trucks—was not available for operating costs. The same food bank was later criticized by funders because it showed a $200,000 annual deficit—a deficit that could be traced to a change in the timing of a food drive and the accompanying reduction in inventory of donated food. Of course, this did not represent poor financial management, though it was perceived that way.

It may appear unbelievable that Read Now was criticized for its "excessive" overhead costs and threatened with loss of funding. Yet, the funder relied on Form 990 information, not knowing that hundreds of thousands of dollars of donated program services are excluded by IRS rules from the portion of that form showing program expenses.

There are several points here. First, nonprofit accounting has primarily been inherited from forprofit accounting, yet nonprofits face a unique situation. When capital and in-kind contributions are accounted for in standard ways, non-expert users looking at annual surpluses or overhead ratios can easily be led astray. Also, in the forprofit world, audited financial statements are the public document, and corporate tax returns are private. In the nonprofit world, it's the reverse: the 990 is public, but in most states, audited financials need not be. Form 990's deviations from GAAP can mislead users who are not financial experts. In addition, the public accounting profession's culture is primarily focused on the accuracy of audited statements.

Thus, financial professionals must revamp nonprofit accounting and reporting to make the financial condition of nonprofits more transparent and increase the information's overall quality and accuracy. Foundations concerned about the quality of financial reporting and the decisions based on that information may wish to invest in this area.

Reflecting on Capacity Building

The new emphasis on capacity building recognizes the widespread fragility of nonprofit organizations and the necessity of good management for long-term mission effectiveness. To help an organization build its capacity, funders designate certain funds solely for that purpose.

The study provides an important perspective on this strategy. First, it suggests that common nonprofit weaknesses stem from systemic factors, such as the effect of underreporting overhead costs and the ways in which this misleads funders about how much overhead is enough. Such systemic factors can never be addressed by providing grants to one organization for board development and to another for computer purchases. Second, the study implicates restricted funding as an important contributor to the capacity problem, which questions the wisdom of establishing yet another category of restricted funding—capacity-building funds—to solve problems created or exacerbated by that very practice. Perhaps if we addressed the systemic underinvestment in the items nonprofits need to accomplish their missions, the capacity problem would also disappear.

Choosing Self-Governance

As of press time, the Senate Finance Committee is considering additional rules and requirements for nonprofits. A typical public sector response, this process was triggered in part by a number of high-profile scandals. Unfortunately, the findings of the Nonprofit Overhead Cost Project reveal an almost limitless potential for additional scandal within the sector, based on widespread underreporting of overhead expenses and the common practice of using individual contributions to pay for overhead—to name just the two largest and most sensitive issues. If we hope to have a legislative and regulatory framework that we can live with, the sector must address these ticking time bombs before they go off.

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Additional Resources

In addition to study results, information related to the Nonprofit Overhead Cost Project (http://www.coststudy.org/) includes:

• Guides for donors, nonprofit boards and financial professionals  
• Research briefs on overhead costs, overhead reporting, efficiency ratios and related topics  
• Conference papers and presentations  
• Links to tools and assistance with cost accounting and reporting.

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