Calculating overhead rates and managing overhead expense are important staff roles. Board members are not required to know how do staff accounting work, but we do need to bring an informed perspective to our oversight:
Amid the crosstalk about nonprofit overhead, board members and staff do need to understand what the conversation is really about, and how to interpret "what is overhead" for our own organizations. Here are eight key ideas to know about overhead:
1. Apples, oranges, and alligators: One of the more surprising facts about overhead is that while it seems that everyone is talking about it, everyone is actually talking about the different things. The word "overhead" isn't an accounting term, so different people define it differently.
Some accounting terms which are similar to “overhead” and often confused with it are:
- Indirect costs
- Administrative costs
- Shared costs
- Fixed costs
In one study, respondents were asked which of the above was the closest synonym to "overhead." No synonym got more than 40% votes. In other words, any two people talking about overhead are statistically likely to be talking about different things without realizing it.
Takeaway for board members: in any conversation about overhead, get everyone to agree on a definition before the discussion gets very far.
2. Many community nonprofits mistakenly overstate their overhead on IRS Form 990 -- which is what raters use to calculate overhead.
The IRS Form 990, which is the financial and program information for required of most nonprofits annually, divides all costs into three "functional expense categories":
- Program Service expenses
- Management & General expenses
- Fundraising expenses
Unfortunately, the term "Management & General expenses" is often interpreted or misinterpreted differently. An example: an organization with three staff brings families together who have children with disabilities; their titles are executive director, office manager, and outreach manager. This nonprofit may well classify both their executive director's and office manager's time -- 67% of their personnel costs -- as "management and general." Charity raters use this number and will declare this organization to have 67% overhead.
In fact, a closer look at their time would show the executive director to spend 70% of her time on Program, 20% on Management and General, and 10% on Fundraising, and the officer manager -- who answers the parent hotline -- to spend 60% of her time on Program and 40% on administrative tasks. Once properly understood, the organization's "overhead" rate is actually 23%.
Another challenge with the Form 990’s functional expense split is that nonprofits can't include the value of donated volunteer time so all-volunteer and volunteer-based organizations look even worse.
Takeaway for board members: Look at your nonprofit's Form 990 and ask if staff time and other shared expenses are being proportionately charged to programs and not inappropriately lumped into "Management & General." And even though you can't report volunteer time in the financial section of the 990, you can describe it in the section on Program Accomplishments.
3. A quick quiz. Which type of expense is rent?
- Program Service?
- Management & General?
Answer: It depends. . . if you rent a community center auditorium to serve senior lunches, it's a Program expense. If you rent a separate office for your admin offices, that's a Management & General expense. If your grantwriter works out of shared Hub space, that's a Fundraising expense. If they all share offices, the rent is a shared cost, and can be apportioned by a variety of acceptable methods.
Takeaway for board members: Talk with the organization's auditor or accounting advisor -- or ask the Board Treasurer to do so -- to be sure your nonprofit is using one of the acceptable allocation methods that minimize your Management & General and Fundraising expenses.
4. Sometimes more overhead = higher efficiency.
Some types of overhead are not only necessary, but actually indicate more efficiency, not less: Imagine two organizations, each with three programs. In Organization A, each program has its own copier. In Organization B, one copier is shared by all three programs.
As a result, Organization B has a higher overhead rate than A.
In addition, newer organizations and movements along with more controversial causes have higher fundraising expenses. For example, at the beginning of the environmental movement, such organizations had a very difficult time even explaining what "the environment" is and that clean air and safe foods were important, achievable goals.
Takeaway for board members: If your organization's overhead rate is higher than some others, look at the context of its lifespan and the newness and controversial-ness of its cause as part of the board's review.
5. Charity Navigator re-assigns numbers from Form 990 to make overhead appear higher.
The IRS and Generally Accepted Accounting Principles (GAAP) allow for proportional allocation of "joint costs" such as a mailer that combines education (perhaps about wildlife or autism) with a request for donations. The costs of this mailer can be split between Program and Fundraising using an accepted measure such as the number of text lines.
However, Charity Navigator re-assigns all joint costs into Fundraising. There isn’t much you can do about this, but it is important to know and reinforces that different people define and calculate overhead differently.
Takeaway for board members: If you look at Charity Navigator ratings, remember that Fundraising costs are probably over-reported there. And as a board member, look up your own nonprofit at charitynavigator.org and at GreatNonprofits.org.
6. Nonprofits that claim 0% overhead or that "100% of your donation goes to children" are probably playing games with words and numbers . . . and hurting other nonprofits.
In a desire to be able to claim 0% overhead, some nonprofits and workplace giving organizations ask certain donors to designate their donations for administration. We know one foundation where the parents of the 20-something staff make donations that are designated to pay for staff time, the audit, the rent, and so forth. As a result, this foundation can claim that "100% of your donation goes out in grants."
These claims are at best a marketing gimmick and, at worst, dishonest. Every nonprofit requires some overhead, just as every business does. A nonprofit may use this declaration to appeal to donors, but they end up putting pressure on other nonprofits to artificially under-state their overhead.
In addition, overhead costs are crucial costs: liability insurance, staff training, computers and fundraising staff are all necessary costs. Overhead is necessary for credible financial statements, quality services, safe facilities, and the costs of fundraising.
Takeaway for board members: If you are on the board of a nonprofit that uses this language, share this article with the executive and the fundraising staff. Make sure your organization emphasizes what you accomplish and what you stand for, not how you account for expenses.
7. Understanding your nonprofit's overhead and reporting it right is important.
It is also, of course, possible to have too much overhead. All of us want to be sure that our nonprofits don't have too many administrators or spend too much money on management (even though we realize that management is necessary to meet our mission). Most of us know at least one organization that has slid into spending too much money on process and bureaucracy.
Takeaway for board members: Make sure at least the board's finance committee understands how you are reporting overhead, and make an effort to keep it within 30% or so -- a fairly common informal rule of thumb. If your overhead rate seems high, work with the staff to see if you are inadvertently over-reporting overhead costs, or whether administrative costs can reasonably be reduced. If your overhead rate is substantially below 30%, talk with the staff about whether there is adequate accounting support, staff development activity, HR support, technology, facility space, and fundraising capacity. Community nonprofits typically are too lean when it comes to management and fundraising, rather than overstuffed with bloated accounting departments (for example).
8. Indirect cost rates in government contracts may be changing -- getting your nonprofit's contracts closer to paying the full costs of funded programs.
Government contracts with nonprofits -- for medical care, for homeless services, for public art -- often specify indirect cost rates as low as 3%. Studies show that 54% of nonprofits have government contracts that do not pay for the full costs of the program.
New OMB guidelines taking effect December 2014 say that contracts with nonprofits involving federal money must have a minimum of 10% overhead. This isn't enough, but it's an important victory for nonprofit advocates. It is also important for nonprofits to know the true costs for delivery of their services – and overhead is part of this cost. This way they can continually remind donors and government officials that impact does not come without a cost.
Takeaway for board members: If your nonprofit has government contracts, make sure the staff knows about the new rules and brings them up with their contract officers.
Finally, keep this in mind:
And as individual donors and members of our communities, we need to remember that when we purchase something -- let's say a chair -- we aren't concerned with how much of the price is due to wood and nails compared to the manufacturer's insurance costs. If the price tag broke down these items, we would consider it very odd. What matters is whether the chair is a good chair and offers a good value. When we consider donating to a nonprofit, we should ask: Do they do important, good work? Are their values in line with mine?
Thank you to the following experts for this valuable information.
Jan Masaoka is publisher of Blue Avocado and the CEO of the California Association of Nonprofits. She is a former instructor of nonprofit finance in Golden Gate University's MPA program.
Steve Zimmerman, CPA, MBA, is principal of Spectrum Nonprofit Services in Milwaukee and a regular contributor to Blue Avocado. With Jeanne Bell he co-authored The Sustainability Mindset: Using the Matrix Map to Make Strategic Decisions to be released by Jossey Bass later this year.