What's the relationship between overhead and outcomes?
What is the overhead cost ratio? Can focusing on overhead hurt the charity sector? What’s the relationship between overhead and outcomes? Are there better ways to measure charity effectiveness? These questions are answered in this episode.
You’ll hear from Hala Altamimi, an Assistant Professor at the University of Kansas. Hala’s research focuses on efficiency and effectiveness in the public and nonprofit sectors.
Find out more about Hala:
Find out your organisation’s overhead ratio – which, as a reminder, is the spend on overhead over the total expenditure of the organisation – and then have at least one conversation in your organisation about whether you think this is too low or too high, and why.
Resources and links
In the order of appearance:
Hello, and welcome to this opportunity for you to learn, develop, and contribute more to your cause.
Today you will hear from Hala Altamimi, an assistant professor at the University of Kansas. Hala’s research focuses on efficiency and effectiveness in the public and nonprofit sectors.
You will learn what the overhead cost ratio is, how over-reliance on it contributes to the nonprofit starvation cycle, what the optimum level of overhead appears to be for arts organisations, how we should think about measuring the effectiveness of nonprofits, and much more. Enjoy.
Hala, it’s lovely to have you. So to start off, could you talk to us about overhead cost? And – specifically – do you want to talk to us about what the overhead cost ratio is?
Thank you for having me.
Generally speaking, nonprofit expenses can be divided into three categories: programme, administrative, and fundraising expenses.
Programme expenses are directly related to the goods or services being provided by the nonprofit. For example, expenses for providing health care, delivering music performances, or delivering food or clothing to the homeless, are all considered programme expenses.
Overhead costs are expenses related to activities that support an organisation’s programmes, but cannot be directly linked to them. These typically include administrative expenses, such as executive salaries, accounting fees, and insurance. Also, fundraising expenses, which are related to conducting fundraising campaigns and events and soliciting donor contributions.
Now, the overhead cost ratio is the proportion of these two categories, the administrative and fundraising expenses, out of the total expenses of an organisation or the total budget of an organisation.
And that overhead cost ratio is something which I understand you feel donors have become over-reliant on as a measure of nonprofit effectiveness.
And we – I say we – donors think that the lower the ratio (as in, the lower the overhead costs to the expenditure) the more effective a charity is being. Could you outline some thoughts as to why you think donors think that? And then also, how that might be a bit problematic?
Sure. The overhead cost ratio has been used as a proxy for nonprofit efficiency and effectiveness. Donors have relied on the ratio to identify and compare nonprofits that make the most efficient use of resources.
The conventional wisdom in the sector is that lower overhead, as you mentioned, indicates higher organisational efficiency. Donors assume that high overhead is a sign of inefficiency. And if nonprofits spend more on overhead, then it’s not maximising the value from the donor dollar toward the programme and the people who need it the most. But this is not necessarily true. And this is the problematic part about it.
A nonprofit with higher overhead could be more efficient and effective than a nonprofit with lower overhead. And this conventional wisdom has made donors reduce their donations to nonprofits with high overhead.
Studies show that donors strongly favour nonprofits with low overhead, regardless of their effectiveness in achieving their missions. When donors expect nonprofits to keep their overhead expenses down, that puts pressure on nonprofits to conform to those expectations, and deprive themselves of resources essential for their effectiveness, causing a phenomenon known as the starvation cycle.
So essentially, we’re getting to a form of competition, I suppose, and a market for funds where you could potentially get to a race to zero where each charity is competing with each charity to have the lowest possible overhead costs. And that can lead to what you mentioned of the nonprofit cycle – sorry – the nonprofit starvation cycle. And I’m interested what is that?
Yeah, that competition part is a big part of the starvation cycle.
So the cycle describes a self-reinforcing feedback loop of unrealistic donor expectations about how much charities or nonprofits should spend on overhead, competitive pressures, and misleading reporting in the sector.
Initially, funders hold unrealistic expectations about running a nonprofit organisation with low overhead. In response, nonprofits feel pressured to meet those expectations to attract funding. This is the competition part. Because there are limited resources in the sector, those who spend low would be more attractive to donors.
They may then need to spend too little on overhead by paying low and non-competitive salaries, replacing paid staff with volunteers. and using outdated facilities and equipment. Alternatively, they may miss report their expenditures to satisfy donors’ demands.
Either response feeds back to donors’ unrealistic assumptions and creates this cycle that slowly but steadily starves nonprofits and weakens their infrastructure.
It’s difficult. I’ve been in fundraising before, and I’ve experienced exactly that. You go for funding… and I mean, sometimes I’ve… I won’t name any names out of politeness… but there have been some funders who say absolutely zero overhead costs, we won’t fund it at all, we only want to fund the programme costs.
Which I mean, as a fundraiser is… I find it difficult to then… because then what you’re left with is “oh, I have to actually fundraise overhead-only costs from somewhere else”. And no one wants to – well, very few people will – fund overhead costs. So you have to then get that from unrestricted funding. So, makes it very, very difficult for a charity.
And I suppose then, what do you think, are the typical arguments for having less? Do you think that this started as a noble idea of charity should be overall mindful of the amount that they spend on overheads? And then when fed into the feedback loop, which you’ve just described, then created where we are now? Or what’s your opinion on why? And if you had to steelman the argument for having lower overhead costs, what would you say?
So there are different arguments about the overhead cost ratio. But in general, if you were to ask me what caused this reliance on the overhead cost issue ratio, I will tell you that one prominent factor is the challenge of measuring effectiveness and impact in the nonprofit sector.
In the private sector, there is a clear bottom line. Companies at the end of the day, look at the profit to determine if they are doing well or not. In the nonprofit sector, there is more complexity and nuance about how to measure success, and what the bottom line is. So there is no simple or standard metric to measure the efficiency and effectiveness of nonprofit organisations.
As a result, the sector has relied on proxies such as financial ratios. And one of them is the overhead cost ratio.
In the private sector, similar expenditure as the overhead may go unnoticed as long as you are making a profit, but in the nonprofit sector, knowing whether organisations are doing well or not gets more complicated because of the emphasis on successful missions and how really do you measure success in the context of nonprofits. So, financial ratios have become popular because of this issue of lacking standard and simple metrics for measuring mission success and also because of the overall trend of professionalisation of the nonprofit sector and trying to have more easily accessible information for accountability reasons and especially that the sector has gone through a series of scandals.
Another factor that helped in this reliance on the overhead cost ratio is the appearance of charity monitors such as GuideStar here in the US, Charity Navigator, and the Better Business Bureau that have created profiles that compare nonprofits on financial information. And sometimes they spell out the percentage that you need to maintain to be considered efficient.
In terms of theoretical assumptions, I don’t know if we have time to go into this. But one main assumption about why there needs to be less overhead is in the principal-agent theory. So high overhead is considered problematic because it can be a sign of agency problems.
So policymakers, board of directors, and donors delegate work to nonprofit managers to perform their assigned duties and responsibilities. There are some key assumptions that govern the principal-agent relationship. One key assumption is related to rationality, and managers are rational and seek to maximise their self-interest. Another assumption is that managers have more information than board of directors, donors, and policymakers about what happens inside the organisation. So managers may take advantage of this information asymmetry and maximise their self-interest rather than the public interest. These imperfect incentives promote inefficiencies that hurt performance. So managers may mismanage financial resources, they may take multiple salaries, consultation fees, sign fundraising contracts with family members or friends, or spend ridiculous amounts on conferences and travel expenses. In this case, a low overhead acts as a monitoring mechanism for donors and other stakeholders to ensure that their contributions are devoted to programmes then that maximise social impact.
Interesting. So if I were to be very, very cynical – which I’m prone to being – it sounds like it’s, to a certain extent, a little bit of laziness from all sides.
From the donors’ point of view, it’s a little bit of laziness of not wanting to go into, and measure, something more nuanced than financial ratios. And making sure that we have low overhead is because people are too lazy to properly manage middle managers to make sure that they’re not doing things that they shouldn’t be.
But let’s give people a bit more credit. I think we all look for the path of least resistance. So I think it’s little wonder that we have found – or come across and settled on – a ratio, which makes things easier, despite being problematic, perhaps, in its ultimate manifestations.
I’m interested to get your thoughts on what could be better measures, but we’ll come back to that.
Because I think it would be natural for someone listening to the issues of low overhead to think, “oh, okay, so we’ll just spend whatever we like on overhead, then”. You know, the more the merrier. So, do you want to respond to that?
Yeah, that’s a great point. So, there’s a pressure to reduce overhead. So there’s the ‘less the better’, but also, assuming that we can endlessly spend on overhead is problematic. The saying as you said, ‘the more the merrier’, or ‘the more overhead the better’ should not apply here. Because from an economic efficiency perspective, there must be a limit for overhead spending, and any increases in overhead beyond this limit may yield negative returns.
Right. So there’s a Goldilocks zone of overhead spending. And that gives us a segue into your study, which I read and found you via.
Do you perhaps want to go through then what you were looking at? I mean, we spoke about what you were looking at, but you want to perhaps talk about what you studied and what you found?
Yeah, sure. This study is co-authored work with another professor at Florida Atlantic University. We looked at the relationship between the overhead cost ratio and nonprofit programme outcomes. And instead of adopting one view that the more overhead the better or the less overhead the better, we reasoned that there should be an optimum point, after which spending more on overhead stops enhancing an organization’s performance.
In our perception and conceptualization, we think that there is merit to both arguments. So that gave us the hint about the optimal point.
In other words, we wanted to see how much overhead is enough, and how much is too much. And to do this, we analyse a big data set on arts and culture nonprofits in the US, from the years 2008 to 2018. So it’s longitudinal data. We looked at what year of their budget covered overhead, which is the overhead cost ratio, and its relationship to programme outcomes. We looked at how many people attended the programmes of these arts and cultural nonprofits as a proxy of outcomes or success.
And we found that when arts nonprofits devoted about 35% of their budget to overhead, they did the best in terms of attendance. In contrast, attendance declined for organisations that spent extremely low and high amounts of their budget on overhead. And if you want exact numbers, groups that spent far too little, saw attendance losses by 9%. And attendance for arts, attendance for art groups that spent too much on overhead also fell by 30%. So spending too little is not good. And spending too much is not good. And the optimal point for this sample was 35%.
The optimal point was 35%. Blimey.
Yes, we had different specifications, model specifications, but this is in terms of total attendance. Yes.
And this brings into light, I think, how skewed we are. Anyone who’s done any work with donors knows that even the most generous of donors, in my experience, don’t come close to those sorts of numbers. I mean, I think the most I’ve had is probably about 15% permissible overhead spend. So we’re a little bit far off that optimal point.
Do you think… I know that you will laden me with caveats, as researchers often do, so we’ll proceed with caution.
Do you think that the optimal figure is going to vary in different types of nonprofits? So I suppose let’s start by talking about within your own data set, how much variance there was in the optimal? And then if you were to then think about how that might extrapolate out into the wider population of nonprofits, what you would say? And whether there’s any things we should keep in mind?
Yes, you’re completely right, that there are many caveats when it comes to research, and I’m gonna acknowledge them.
But let me start by saying that, in the US, in the more generous recommendation side, as you said, there’s a lot of variation. So some recommendations are very stringent when it comes to overhead and some are more on the generous side. But charity monitors typically recommend that the overhead cost ratio doesn’t exceed 25%.
But the 35% optimal point we found is much higher than this rule of thumb. And in terms of our sample, the average before the analysis, because we’re analysing arts nonprofit was 27%, which still shows that there is a big difference. Those findings actually uncover a deficit in overhead spending in the arts and cultural sub-sector.
And to some extent validates the argument that nonprofits need to invest more in building their productive capacity. That said, here’s the caveat. The goal of this study is not to recommend a new benchmark for the sector, but to challenge those unrealistic expectations about how to run a nonprofit and focus donor attention more on impact and results. Because emphasis on overhead diverts the attention away from more involved, informative data on charitable outcomes.
So the purpose of this study is to encourage donors to move away from this thinking that one ratio should fit everyone or suit all organisations. Expectation to supporting the overhead levels necessary for the success and sustainability of nonprofit organisations.
And you are exactly right, there will be differences among organisations. And this is why we don’t want the attention to be on the numbers we found. Optimal overhead levels vary depending on several factors. For example, programmes that charge admission. Paid programmes may need more overhead than free programmes to attract an audience; that’s in the context of the art sub-sector.
Another factor is the growth stage of the organisation. For example, newly established organisations may need to spend higher than normal or average overhead to start their operations and keep them going.
The type of nonprofit also matters. Whether it is a health nonprofit, arts nonprofit, or a human service nonprofit. For example, performing arts nonprofits usually spend more on travel costs, because they need to go and do their shows in different venues and places. Also, museums often incur higher building costs and maintenance and security costs.
As you can see, it varies from one organisation to another. So holding all organisations to the same number is not the point here.
And if I were to bestow on you, the title of president of nonprofit organisations worldwide – a pretend title, which I’m just making up but – Hala, you are that person now. No pressure. What should we be looking at? Or what would you be telling donors… decreeing to donors… to be looking at instead?
Definitely not the overhead cost ratio in isolation of other information. The ratio can tell you informative… can have informative data and can be meaningful, but not in isolation of other data.
I would recommend – and again, I don’t know if I can be in that role; it’s a lot of pressure – but I think the focus should be on impact and whether the nonprofits are actively achieving their mission. So donors, at the end of the day, need to see ‘okay, how did you spend this money?’ But also, ‘did you achieve what you said you wanted to achieve with this money?’.
Usually high-impact nonprofits – and there has been some analysis and some reports – typically have higher overhead expenses. But at the end of the day, they are still achieving their mission. They are reaching broad audiences and they are doing some amazing results.
And some other sectors that donors should look into is the leadership. How the leadership is doing? How is the nonprofit being transparent or not? How is the overall governance within the nonprofit? And it’s not just one simple ratio that make you determined that this nonprofit is not good.
At the end of the day, again, donors want to see results, want to see impact, and in order to do that, overhead is critical. Because you cannot achieve results without executive salaries; you want highly skilled staff, you want to be competitive. You want also to build your resilience and adaptive capacity. And you want to make some performance metrics for your own organisation. And to have good, for example, IT and good technology in your organisation to support the production of results.
So, again, the emphasis should be on achieving high impact and explaining to donors how overhead can play a role in achieving this impact.
So, if I were to take an inference, I think it sounds like we would need to get a little bit more – excuse me – we would need to get better at having conversations between nonprofits and donors at a start of a grant agreement and saying, or even at the application stage, or wherever it is, just say, “Look, this is how we measure impact. Is this how you think we should be measuring it?”. Well, not even… No. We shouldn’t be asking that of donors. Let me rephrase that, “this is how we measure impact, this is the impact we’re hoping to achieve, this is how much it costs”. And then figuring out from there what’s acceptable in terms of whether funding has been ‘successful’.
So I suppose the criteria for each nonprofit is going to be different. And we should be having conversations with donors about what those are. It makes things more difficult. But it would be perhaps a better thing. Am I on the mark there? Or is that maybe a bit too far?
You’re always on the mark, Zac. No, you’re definitely on the mark.
I think yes, there is a missing link in that nonprofits do not explain their needs. They also follow the conventional wisdom in the sector, which hurts them and hurts other organisations. And so I think there is a responsibility that falls on nonprofits in explaining to donors and other funders their needs, especially in terms of overhead spending, and being just more transparent.
Recently, there has been some interesting studies that show that transparency about overhead really helps. So when donors have more information about the purpose of higher overhead, and what are the causes of this high overhead, they tend to give more to nonprofits with high overhead and not just completely dismiss them. So just have an open conversation.
And there has been ongoing efforts by nonprofit researchers and scholars, by some foundations, and also charity monitors themselves, to adjust donor demands and expectations. And our study falls into that category. We want to try to break – if you may – this overhead myth and try to collect more data that helps evaluate nonprofit performance and not just rely on one simple measure.
Again, the overhead ratio can communicate useful information, but only along with other performance and impact metrics.
Brilliant. Well, I actually think that’s an amazing soundbite to end on. I think that’s a great rounding off of our conversation.
I’d like to thank you for being part of this conversation and contributing to research that hopefully will help us get to a point where we are more transparent, we aren’t relying on single proxy indicators to make decisions on nuanced and complicated decisions. If people wanted to find out more about you, where should they go to find out more about your work?
I have a web page through my University, the University of Kansas School of Public Affairs, you can type in my name. Also, my research is published. And I have a Google Scholar profile. So if you type in my name, you will get to know more about my work.
Perfect. I encourage people to do that.
And feel free to out to me via email. If you have any question, if someone has a question, I’m happy to answer them.
Oh, there you go, everyone, an opportunity to reach out and speak to Hala, if you had any questions that you were really hoping that I was going to ask, and I didn’t. So there we go. Well, thank you so much for your time, and I will see everyone next time.
Thank you for having me, Zac.
Hello, me again. I have some homework for you.
Your homework is to find out your organisation’s overhead ratio – which as a reminder is the spend on overhead over the total expenditure of the organisation – and then have at least one conversation in your organisation about whether you think this is too low or too high, and why.
You can find a link to the transcript and resources in the description of this episode.
If you liked this episode, then don’t forget to subscribe for more. And the best thing that you can do to support this show is to tell other people.
I hope to see you next time.