Ramadan is here: What you need to know about nonprofit overhead costs!

Originally published on LinkedIn

Ramadan is upon us. As well as being a month of fasting for over 1.8 billion Muslims all over the world, it is of course the season for charitable giving. Globally, billions of dollars are donated each year to an array of great causes. (If your organization isn’t running a Ramadan campaign, you’re missing out on major funds!)

With this in mind, many donors are thinking about which causes and organizations to support. One natural question many donors ask at this time of the year is one that many nonprofit leaders dread, the overhead question! How much of your organization’s expenditure goes to overhead costs? (Also known as admin costs.) 

While I have written this piece with US donors in mind, the ideas and principles outlined here apply to all donors globally.

Nonprofit organizations exist to serve a higher mission. Whether that be ensuring villagers who lack access to water no longer have to walk miles for clean drinking water, or ensuring children with disabilities are able to lead fulfilling lives. In order to provide beneficiaries with the best service possible, these organizations spend not only in the direct programs they implement but in a range of other areas. They invest in recruitment, staff training, planning, evaluation, and in internal systems— as well as in fundraising efforts that enable them to both sustain the organization and grow it so that they can implement more programs and help more people in the years to come.

The percentage organizations spends on overhead can vary each year. It depends on a number of factors, including where they are in their growth cycle (we can’t compare a 2-year-old organization to a twenty-year-old one), the number of programs finalized within that fiscal year (often delays happen in programs that mean organizations can’t spend the funds as quickly as they would like), and many others factors.

Contrary to common opinion, the amount of money a charity spends on overhead is a poor measure of its performance. America’s leading sources of information on charities (BBB, GuideStar, Charity Navigator) all agree that overhead alone does not tell you much about an organization’s sustainability, culture, competency and most importantly impact. You may be surprised to read their conclusion that many charities should spend more, not less, on overhead (http://overheadmyth.com/). As outlined in their letter, donors this Ramadan should be thinking not just about overhead, but about other telling factors of an organization’s performance such as transparency, governance, and leadership.

However, none of this is to say that overhead costs should play no role in your decision to support an organization. The overhead ratio of an organization can indeed offer real insight into how the organization operates and can be a valid way of noticing poor financial management. That’s why it’s important to know exactly what to look for when judging an organization’s real overhead costs.

Unfortunately, audited financial statements and IRS 990 tax returns can be difficult to decipher and understand, often leaving donors with an unclear picture of an organization’s financial health. The fact that the IRS does not enforce industry standards across the board also makes it practically impossible for donors to conduct a like for like comparison. Unfortunately, nonprofits are largely free to choose which expenditure to allocate to programs, what dollar value to assign to non-cash donations and how to calculate beneficiary numbers (these are just some areas where standardization is lacking). Whereas one organization may allocate 5% of its digital marketing costs to programs, another may allocate 65%. Where one organization will allocate 35% of the CEO’s salary to programs, another may allocate 85%. Without industry standardization, it becomes practically impossible for donors to compare apples to apples. 

With this in mind, below are some metrics you should be looking at to help you better understand an organization’s financial health and its way of operating:

 -      What is the organization’s cash revenue vs non-cash revenue? (Form 990 page 9)

-      What % of cash revenue is spent on overhead? (Look at non-program spend on the audited financials and compare that to the cash revenue.)

-      What was their net cash balance at the end of last year? (Look at the audited statements. Too little cash on hand means the organization could be struggling and may not be sustainable. Too much cash in the account could mean the organization is not spending enough on the mission it exists to serve.)

-      Compare the salaries of the executive team to other similar organizations in size and location. What % of the organization’s cash revenue is going to executive salaries? (Form 990 page 7)

-      Does the organization’s expenditure breakdown look feasible/realistic/accurate to you? Do their fundraising costs look too high or too low? What is the return on their fundraising investment? (Look at the Statement of Functional Expenses on the audited reports to see a full breakdown.)

-      Is the organization accredited by the Better Business Bureau?

-      What Seal of Transparency, if any, does the organization have from GuideStar?

-      Does the organization regularly change the audit firm/partner that conducts their financial audit or has the same person been doing their financial audit these last 10 years? (It’s best practice to change auditor every 4 years or so.)

-      Does the CEO or Executive Director have family members on the board of the organization?

-      Has the CEO or Executive Director hired family members as employees or contractors?

-      How long has the CEO or Executive Director been in the role? Is there a healthy turnover of leadership?

-      How long has the Chair of the Board been in the role? Does the organization's bylaws include term-limits for board members to ensure a healthy turnover?

(Many donors rely heavily on Charity Navigator. Please note they do not rate nonprofits that have been in operation for under 7 years and there have been serious concerns raised about the ways in which the platform focuses rather arbitrarily on certain metrics which do not do justice to an organization's impact and in fact force organization's to focus on quantity over quality (GIK evaluation issue is one example). There are many articles online about the problems with Charity Navigator's approach which I encourage you to read.)

Below I have presented the financials of two US based humanitarian organizations to help underline the points made in this article. These two organizations are funded in large by public donations and are similar in scope and nature. The numbers have been simplified for the sake of ease and to protect the identity of the two organizations.

 1)   Organization A on the face of it is spending 10% less than Organization B on overhead costs. Amazing right? Well not quite. When you dig a bit deeper and look at how much of their cash contributions are going to overhead, you will see that in fact organization A is spending 44% of its cash contributions on overhead, whereas Organization B is only spending 22% of its cash contributions on overhead costs.

2)   The CEO of Organization A is paid $225,000 – that’s 5% of the organization’s cash revenue, whereas the CEO of Organization B is paid $130,000, that’s 1.4% of the organization’s cash revenue.

3)   Look at the net cash balance of each organization at end of year. What does this tell us about the financial health of each organization?

4) It's important you compare an organization's 990 Form to their audited financial statements. From Organization A's 990 Form, we can see that a number of their fund development executives received salaries of over $100,000, yet this is not reflected in their audited financial statements which show them as having spent less than $30,000 on fund development. This means the cost of these executives has been allocated to either programs or general management.

What the table above does not show us is how transparent the organizations are, what methodology they use for allocating program versus non-program costs, what type of work culture exists within these organizations, what methods the organizations use to calculate the dollar value of donated goods, and the competency of the board directors in performing their governance and fiduciary duties. These numbers also tell us nothing about the impact these organizations are having on the causes they exist to serve.

Donors should indeed look at the overhead spend of organizations they support this Ramadan, but this metric should be one of many used to help select which organizations to support. I have tried, through a simplified way, to outline how difficult it is for an uninitiated donor to judge which organization to support. When looking at the overhead ratio, we need to make sure we know exactly what to look for and which questions to ask. Asking simply for a percentage is not good enough. Numbers can help give us a rough idea of how an organization operates, but they cannot show us the full picture. To get the full picture we need to engage meaningfully and regularly with the nonprofits we support in order to understand their rationale (assuming they exist) behind accounting and sending decisions.

I hope you find this contribution useful as you sit down to plan your giving this Ramadan!

Oussama Mezoui