Insight | August 18, 2016

Reversing the Starvation Cycle: A New Way to Think About Overhead in Nonprofit Funding

By Vanessa Tribastone , Willis Zhu and Lena Backe

A recent Senate report has stirred up public attention on the spending practices of the American Red Cross (ARC)  in Haiti, calling out the organization’s expenditures on management, general expenses and fundraising, program costs, and a contingency fund: 25 percent of the $487.6 million ARC received in donations for Haitian earthquake relief. This reaction is an example of a sentiment often expressed by those outside the nonprofit sector: that “overhead” expenses should be minimized. Even many of the organizations that control the philanthropic purse-strings within the sector have historically believed that leaner nonprofits are more efficient and impactful in terms of programming.

An article in the Stanford Social Innovation Review’s (SSIR) May issue, entitled “Pay-What-It-Takes Philanthropy,” approaches this issue of nonprofit spending from a different perspective. Highlighting a recent study by The Bridgespan Group, the SSIR article discusses whether the strict spending requirements placed upon non-programmatic spending within nonprofits were actually realistic or effective in supporting organizations to achieve their program goals. Instead of measuring “overhead” spending, which lacks a clear definition, the Bridgespan study focused on “indirect costs,” defined as costs not attributable to a specific project. This definition includes four categories: administrative costs, network and field costs, physical assets, and knowledge management; it notably excluded fundraising costs.

From polling 20 high-profile, high-performing nonprofits, Bridgespan found that indirect costs ranged from 21 percent to 89 percent of overall spending, with the median falling at 40 percent. This figure stands in stark contrast to the 25 percent cited in the ARC case, much less the 15 percent overhead limit often required by foundations. Furthermore, the large range suggests that a one-size-fits-all approach to overhead caps may be out of touch with reality. Just as there is industry segmentation within the for-profit sector representing different company cost structures, there is segmentation within the social sector representing different nonprofit investment requirements.

Under “pay-what-it-takes” philanthropy, nonprofit leaders would “make the case” for additional funding to support indirect costs, in effect turning the oft-cited “starvation cycle” on its head. Discussions with funders would focus on the key components of organizational effectiveness to support nonprofit goals. Critical to “making the case” is the development of robust reporting tools to help nonprofit leaders to better monitor and diagnose cost trends, and support a dialogue of problem-solving and continuous improvement with internal (e.g., managers, frontline staff) and external stakeholders.

The “pay-what-it-takes” approach to philanthropy reframes the grantmaking conversation. It replaces the traditional cap on overhead reimbursement with a flexible approach that is based on real costs. In the words of the SSIR piece article: “It shifts [the emphasis from] what it takes to fund a program to what it takes to achieve impact.”  Nonprofits are encouraged to quantify the real costs of their operational needs and focus on demonstrating how investments can enhance their ability to deliver outcomes, and succeed in serving people and communities.