Wednesday, May 7, 2014

The Overhead Myth: Embracing the Business of Philanthropy

Summary: A recent survey found 62% of Americans believe nonprofits spend too much money on overhead.  Increasingly, the most critical determination of a nonprofit’s effectiveness is a low overhead ratio.  Unfortunately, nonprofits are complicit in focusing attention on how little we spend instead of how much we accomplish.  By perpetuating the “overhead myth” by trumpeting low overhead percentages, nonprofits are caught in a self-defeating cycle.  When nonprofit leaders buy-in to overhead as a good measure of our effectiveness, we place limits on ambition and innovation.  By banding together to push for a deeper understanding of the business of philanthropy, we invite donors to think with greater complexity about our work and the type of investments necessary to make meaningful change.

Originally published by the Colorado Nonprofit Association’s October/November 2013 newsletter, “Nonprofit Colorado.”

The Overhead Myth: Embracing the Business of Philanthropy

The good news for the nonprofit sector is 2013 is the year people started addressing “the overhead myth” in a meaningful way.  The bad news is nonprofits need to adopt a unified front to debunk overhead costs as the best measure of effectiveness which may not be in the best interests of individual nonprofits in the short-term.

To effectively execute its programs a nonprofit must spend money on management to plan and build the infrastructure of the organization and fundraising to cover program and management expenses.  Money spent on these two activities – managing an organization and generating income – is known as “overhead”.  The “overhead myth” is that money spent on these activities is wasteful and donors should avoid funding these activities.  The issue is further oversimplified by using the ratio of overhead expenses to all expenses as the single greatest determinant of a nonprofit’s effectiveness.

Whether or not you work in the nonprofit sector you’ve probably heard some of the following sentiments: “How much of my money actually goes to programs?”  “If it were really a charity the people would work there for free.”  “If they can afford to mail me a fundraising letter, they don’t need my money.”  These thoughts all stem from the perception that nonprofits don’t spend money effectively.  A BBB Wise Giving Alliance survey found 62% of Americans believe nonprofits spend too much on overhead.  

Along with the complex social issues nonprofits address, we also must contend with the general perception that most nonprofits don’t run businesses well.

Over time, this has led to a sector that overtly cannibalizes itself by juxtaposing individual success with a myth we know is self-destructive.  Every time a nonprofit trumpets a low overhead percentage, the myth that nonprofits are generally inefficient is given greater authority.  The nonprofit sector is caught in a self-defeating cycle and it is time to make a collective effort to fight “the overhead myth.”

Three Major Myth Busters

The first signal of changing times was when Dan Pallota’s March 2013 TED Talk, “The way we think about charity is dead wrong”, went viral.  In his talk, Pallota questions why a ratio has become so much more important than results.  He argues that a small nonprofit with a 3% overhead raising $10,000 for the hungry should not be considered more effective than a fundraising nonprofit with 40-50% overhead that raises $100,000,000 for the hungry.  He rhetorically asks, “Although donors are taught to value the low overhead percentage, what would the hungry prefer?”  This highlights a key contradiction of using the overhead ratio as a measure of success: as funders want us to focus more on outcomes than outputs, our primary measure of success is still based on a calculation of outputs.  Pallota asks us to consider whether equating morality with frugality when it comes to nonprofit financial decision-making is an effective way to solve large-scale problems.

In June 2013 came a second high profile effort to change donors’ perception of infrastructure costs.  GuideStar, Charity Navigator, the BBB Wise Giving Alliance issued a joint letter to the American people titled. “The Overhead Myth.”  The three most accessed sources of information about nonprofits said it simply, “The percent of charity expenses that go to administrative and fundraising costs—commonly referred to as “overhead”—is a poor measure of a charity’s performance.”  The groups went a step further to suggest that most nonprofits should actually spend more on overhead.  The letter included the following language nonprofits should use to translate the concept of overhead to donors: “Overhead costs include important investments charities make to improve their work: investments in training, planning, evaluation, and internal systems—as well as their efforts to raise money so they can operate their programs.”  It says a lot about the nonprofit industry and our “watchdog” counterparts that making the case for running a strong business was revolutionary.

Back in 2009, Stanford Social Innovation Review published an article titled, “The Nonprofit Starvation Cycle”, which was highlighted in the “The Overhead Myth” letter.  The article exposes the self-defeating cycle in which nonprofits participate.  The first step is the unrealistic perception of overhead costs held by many donors and funders.  The second step is pressure to conform to the expectations.  The next step is the nonprofit response: “They spend too little on overhead, and they underreport their expenditures on tax forms and in fundraising materials. This underspending and underreporting in turn perpetuates funders’ unrealistic expectations.”  This leads to donors and funders continually expecting nonprofits to do “more and more with less and less – a cycle that slowly starves nonprofits.”

These three developments in breaking the overhead myth were groundbreaking for nonprofits.  The sector finally had external voices arguing that infrastructure is a necessary part of a good business; even, if not especially, businesses dedicated to long-term social benefit rather than short-term profit reports.

Smart Overhead is Good Business

In the private sector, overhead is similarly made up of as “SG&A” (sales, general, and administrative) and is viewed as a necessary element of doing good business.  Different industries have different tolerable ranges of overhead percentages and it is accepted those ratios will fluctuate over the course of the business lifecycle.  While you endeavor keep these percentages low, you also make space for R&D, building your human capital, and the cost of launching new products and acquiring new customers.  If you didn’t spend money on these things, you would be considered a poor business leader.

Imagine you have a friend who is asking you to invest in her new pottery business.  Being a smart investor, you ask her a few questions about her management perspective.

“I see you’re naming your store ‘Poverty Pottery’.  That’s an interesting name.  Did you get any marketing advice before developing your brand?”

“On no…  It’s not about the brand; it’s about the pottery.”

“How are you going to get the word out about your business?”

“I don’t think it’s right to waste money on advertising that could be used making pottery.  I’ll set up a Facebook page.  Maybe I’ll get some friends to set up a table at street fairs on weekends and hand out flyers.”

“What kind of technology are using to track sales?”

“Software is very expensive!  There is an amazing option that exists but I would rather spend money on the pottery.  When in doubt, more pottery!  We are pretty resourceful about plugging holes.  We’ll cobble together some Excel sheets for now.”

“The industry you are working in is extremely complex.  In fact, no one has ever solved poverty, I mean pottery.  How did you find the right people on your staff?”

“I’ve found that people with experience in pottery are incredibly expensive.  I look for people with a can-do spirit and pay them very little.  They don’t stay very long but there are a lot of people who feel strongly about pottery so I can replace them fairly quickly.”

“What are you going to do with my financial investment?”

“Well, I absolutely assure you I won’t invest it in building the infrastructure of my business.  100% will go to pottery.  That’s how effective I am.”

“How are you going to keep this business going with so many challenges?”

“That’s the beauty of it!  I pay myself last and work double shifts when needed.  This business doesn’t work without some sacrifices at the top.  It’s a stretch sometimes but you can count on me.”

“Let me think about this for a day or two.  I mean, it is beautiful pottery.”

After this conversation, it would be clear you were being asked to invest in a business that is destined to fail.  Yet, in the nonprofit industry, the answers above are the functional norms for too many organizations.  Spend as little money as possible on infrastructure.  Only invest in improvements when they are absolutely necessarily and fully funded.  Money spent on overhead is money wasted.  Continually get leaner or your donors will leave you.

What We Can Do to Debunk the Overhead Myth

1. Stop Spreading It!

Nonprofits have been our own worst enemy by embracing the overhead myth when it suits us.  Every time a nonprofit trumpets its low overhead it is tacitly buying-in to low overhead as the most legitimate measure of quality operations.  It’s time to stop focusing on how little we spend and start focusing on how much we accomplish.  Less reporting on ratios, more reporting on results.

This includes Community Shares.  We are rated 4-Stars by Charity Navigator and only 10% of nonprofits achieve this rating for three consecutive years.  Unless significant changes are made to their rating system, I will make the case to my board and staff we should stop highlighting our rating in 2014 or couch it on an educational page about the importance of infrastructure.

2. Translate the Jargon

Explain to your donors what we are actually doing when we are accumulating big, bad, overhead.  Point out smart uses of administrative and management time and funding.  Highlight short-term wins and the importance of long-term planning. 

3. Think Long Term

Identify specific donors (e.g., small business owners, entrepreneurs) that may prefer to support you as investors in infrastructure improvements.  They may even want to play a collaborative role in identifying long-term operations improvements.
In the end, we’re all in this industry together.  When we buy-in to overhead as a good measure of our effectiveness, we place limits on ambition and innovation.  By banding together to push for a deeper understanding of the business of philanthropy, we invite funders to think with greater complexity about our work and the type of investments necessary to make meaningful change.

Alyssa Kopf is the CEO of Community Shares of Colorado and has a MBA from the Daniels College of Business at University of Denver.  Community Shares connects Coloradans to the charities and causes they care about most.  Community Shares features a diverse donor base and an inclusive nonprofit membership base.  With an average donor gift of less than $1 a day, Community Shares has raised $26+ million for Colorado nonprofits.  Connect with Alyssa at