Donors 10% overhead requirements do more harm than good

In the effort to be a good custodian of their philanthropic funds, some donors impose a cap on overhead expenditure (i.e. indirect costs). This amount is typically somewhere between 10%-20% of total grant value.

For example, the Bill & Melinda Gates Foundation is only prepared to fund proposals where indirect costs are limited to 15% of the request.

These organizations, and much of the public, believe that by limiting such expenditure, they will be getting more value-for-money; that the endeavour will be more moral. This belief is based on a superficial view of how non-profit organizations achieve impact.

While there may be contexts when this rule is appropriate, its blind application can easily do more harm than good. I’ve worked with too many good organizations that have had their infrastructure and potential crippled by donors that limit indirect costs to 10%, or slightly more.

Justifiably, this method of funding is frequently referred to as the “starvation cycle” – as organizations invest less in themselves, they become less able to attract more resources, which leads to them investing even less in their capabilities, and so this cycle goes on and gets worse each time.

The capping of indirect costs by donors and governments is an international phenomenon. Hence the existence of a global campaign called the The Overhead Myth, which seeks to communicate the limitations and harm of using financial ratios to judge the performance of non-profit organizations.

This article will explain what is meant by the 10% overhead cap, how it can easily do more harm than good, and how donors can use much better measures to judge the merit of their philanthropic investments.

What is the 10% overhead rule?

Overhead or indirect expenses include infrastructure, marketing and administrative expenses, and non-programme salaries. Many donors believe that organizations that contain these expenses under a set threshold will provide better value-for-money (and are even more ethical) than those that don’t.

This belief that indirect expenses are a “necessary evil”, and that all non-profit organizations have the same business models and operate within the same contexts, is clearly a fallacy. However, it directly affects donors’ approach to funding organizations.

There appears to be little evidence supporting the view that limiting indirect expenses provides better value-for-money for donors. Bridgespan Group recently conducted a study of 20 non-profit organizations that were considered high-performing and used a variety of business models. Bridgespan found that the ratio between indirect expenses to direct expenses was between 21%-89% in these organizations. When recalculated as a ratio of overall costs, this meant that these organizations spent between 10%-45% of their funds on indirect costs.

This study highlights the wide differences in cost structures of these successful non-profit organizations. There should not be a one-size-fits-all rule in this context. For example, I’ve recently discovered how significantly the cost structure of organizations operating in Angola and South Africa differ from one another.

How can the 10% rule harm non-profit organizations?

It may be based on a false allocation of expenses. I’ve worked with non-profit organizations that have understated their direct expenses in their funding proposals because they lacked the financial and budgeting skills to do this allocation accurately. This meant that their proposals and reports provided a distorted view of their cost structure and created a poor impression on donors.

For example, an Executive Director may spend a quarter of their time running projects, or an office may be used to host training workshops, but some organizations may not reflect a portion of these expenses as programme costs.

It undermines smaller organizations which have not achieved economies-of-scale. In such organizations the necessary costs of an administrator, bookkeeper, office, website, auditor etc. may constitute a greater proportion of overall costs than in a much larger organization, though this is not always the case.

For example, I’m working with a small human rights organization in Johannesburg that is doing great work. Its staff are absolutely overwhelmed with the need to run multiple projects so that its donors’ 10% allocations can add up and cover their necessary indirect expenses. This situation can easily lead to burnout and affect the performance of this good organization. Unfortunately, this organization lacks the bargaining power to negotiate more favourable arrangements with its donors.

It undermines organizational sustainability. Closely related to the previous point, a cap on indirect expenses makes it much more difficult for organizations to invest in marketing, technology, research, professional development, knowledge management, fundraising, product development, new infrastructure etc. This can help keep some organizations in a weakened or infantile state; it makes it very difficult for them to invest in their growth.

It enforces the wrong metrics for measuring success. Instead of looking at what positive changes an organization is creating in the world, and whether this is providing value-for-money, it focuses on the cost structure of an organization as a proxy for performance. This undermines innovation and disadvantages those organizations that may have unattractive cost structures but are achieving amazing results and investing in their future success.

There is a famous Ted Talk by Dan Pallotta titled “The way we think about non-profit overheads is dead wrong”. I strongly encourage you to watch this. It describes the impressive return his organization was able to achieve with its investment in marketing and public relations. However, despite the leverage that these expenses were achieving, there was a moral backlash from donors who felt that his expenditure was excessive. Ultimately, the cause of his organization suffered because of its donors’ short-sighted views.

A better approach for donors

A much better approach is for organizations and their donors to be outcomes focused, and to judge their success by the extent to which they achieve their intended changes in the world. In 2007, I wrote a Master’s thesis where I proposed that:

“A non-profit organization or social enterprise is only effective to the extent that it can provide convincing evidence of having achieved its formally-stated outcomes.”

Eleven years ago, my viewpoint was uncommon, even controversial. Nowadays this view is increasingly permeating the social sector in South Africa. I believe it is driven by three main factors. Firstly, the burgeoning field of impact investment where investors want to calculate their return on investment. Secondly, the realization that the billions of Rands of donor money has not achieved its desired impact in South Africa. And finally, the current emphasis of monitoring and evaluation, and increasing knowledge of how to measure social and environmental outcomes.

A big advantage of the shift towards outcomes is how it encourages innovation, as social entrepreneurs investigate how they can achieve more outcomes by adapting their business models and making more efficient use of their resources.

Donors that insist on using financial ratios as a condition of funding or means of judging performance should take “context” into account. They could group organizations in similar contexts (e.g. a country or sector or location) and with similar business models together. Then they could look for a common cost structure. Even then, they’ll have to bear in the mind other differences (e.g. rural versus metro organizations, and large versus small organizations).

I remember how a similar exercise was conducted early 2000s to calculate the funding that home-based care organizations in Cape Town needed to meet minimum treatment standards. The European Union and City of Cape Town ended up determining a fixed fee per carer that each organization employed, and different percentages of each grant for travel, nurses salaries, audit expenses and general administrative expenses etc. This funding was standardized and linked to the number of home-based carers and the territory that was allocated to each organization, based on incidence of HIV. While this example still included specific allocations for each expense category, it was nevertheless based on an analysis of the cost structure of a set of similar organizations operating in a shared context.

However, it is generally much easier for donors to focus on the quality of social outcomes they are achieving with their funding, and to consider whether this represents a good investment. Relax constraints about how an organization needs to function to achieve these outcomes. Focus on results, not the internal cost structure.

Andy Simpson, the director of Imani Development, always reminds me that the field of social development is inherently messy and does not clearly fit on spreadsheets and reports. It takes time and many iterations for non-profit organizations to refine their approach, and for donors to learn the best way to support a particular group of organizations. Over time, clear outcomes emerge and ratios could be calculated for these organizations, but applying them upfront would be reckless and could easily undermine the cause they are trying to help.

What can non-profit organizations do?

What can non-profit organizations do to persuade donors to relax their 10%, 15% or 20% cap on indirect expenses, and cope with these requirements where they exist?

First, non-profit organizations should closely monitor their cost structure, if they are not already doing this. They should strive to understand the concept of “overhead absorption” – the extent to which its projects can absorb the indirect expenses and its optimal ratios for direct versus indirect costs. There is a tension between the need to maintain a certain infrastructure to achieve economies-of-scale and move forward, versus the need to maintain a lean and flexible cost structure. I wrote about this in “How a Lean Cost Structure can Improve Financial Sustainability”.

Second, they can learn how to cost their outputs and/or outcomes, or use a consultancy approach to costing. I’ve previously touched on this issue in my article on “Thinking about Income Generation and Profit”.

Third, non-profit organizations should try and shift their conversation towards outcomes and value-for money wherever possible. Focus marketing efforts on talking about outcomes. Learn how to cost in a way that reflects the efforts taken to achieve long-term impact. Gather some benchmarks from their sector to support their case.

Finally, they should explore how to generate their own revenue and integrate social enterprise thinking into how they operate. This will enable them to subsidize their own indirect expenses and have more flexibility about how they operate.

Conclusion

Non-profit organizations are very aware of the need to monitor and streamline their expenses. However, they need to learn how to move the conversation with their donors towards the socio-economic and environmental outcomes they are achieving. They should seek to define and measure these outcomes and cost their proposals accordingly.

Furthermore, they should strive to build non-financial relationships with their donors where they can understand their pressures and openly discuss the issue of overhead ratios.

The focus of some donors on cost structure and financial ratios as a measure of ethics or performance is a distraction and the wrong approach. They would be better served by focusing on the quality of outcomes that their beneficiary organizations achieve.

Give non-profit organizations the freedom to get results that matter and make a difference in the world. Don’t add additional hurdles and make it more difficult for them to do good work.

Thanks to Andy Simpson and Jaco Slabbert from Imani Development and Philip Anastasiadis for their contributions to this article.

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