In recent years the practice of using overhead ratios to evaluate nonprofit organizations has been tarnished to a certain extent. While it is true that as a standalone measurement devoid of any other context the overhead ratio can easily be misconstrued, completely ignoring this essential metric is misguided. The overhead ratio is a useful tool for private foundations carrying out due diligence in their grant making process.
Let’s take a moment to define overhead in the context of nonprofits and public charities. Overhead is all of a nonprofit’s costs that are not incurred in connection with a specific charitable program. Overhead is mostly composed of managerial, administrative and fundraising expenses. Overhead expenses are necessary to run an effective organization and are not inherently wasteful. Specific examples of overhead include items like management and administrative salaries, fundraising costs, accounting expense, rent, utilities, information technology expense, and general staff training.
So what is the overhead ratio? The overhead ratio is a financial measure of an organization’s overhead costs as a percentage of the total expenses of the organization. It is not a measure of a nonprofit’s effectiveness and it does not measure how well an organization is achieving its mission. But the overhead ratio does cast some light on the operations of a nonprofit. Having an overhead ratio that is too high or too low is a sign that an organization is being operated sub-optimally. An extravagantly high overhead ratio likely indicates the nonprofit is wasting money on nonproductive expenses. A very low overhead ratio can indicate the supporting structures of the nonprofit are underfunded and the programs may not be sustainable in the long term.
Using overhead ratios competently requires careful analysis. In order to get an apples-to-apples comparison only organizations with similar charitable programs should have their overhead ratios compared with each other. A soup kitchen has a completely different cost structure than a disaster relief charity so comparing their overhead ratios is not very fruitful. Soup kitchens should really only be compared with other soup kitchens. When comparing similar organizations, common sense dictates that spending more on programs and less on overhead is a good thing. Cleary a soup kitchen that spends 80% of its budget on providing meals with only 20% on overhead costs is preferable to a soup kitchen that spends 50% on providing meals and 50% on overhead costs. But the overhead ratio should not be looked at in a void. How many meals are provided? What is the quality of the meals? What other factors differentiate the soup kitchens? Overhead costs do matter but it is just one data point in evaluating a nonprofit charity.
Evaluating the effectiveness of nonprofits is very difficult and analyzing overhead is just one piece of the puzzle. Every nonprofit charity needs a balanced amount of overhead to operate its charitable programs and to invest in crucial systems, talent, and training. Although the overhead ratio is of limited value in a vacuum, it is a useful reference point for evaluating nonprofits that should not be disregarded.
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