Some Overhead Costs in Nonprofits Can be a Good Thing

One question I am often asked is “ how much should we be spending on operating expenses?” The truth is, there really isn’t an absolute answer. Many nonprofits choose to minimize or even eliminate to the degree possible any expenses other than direct program expenses or “support to the cause.” Sometimes this can be achieved without a negative impact on the organization. More often these nonprofits experience slow growth or an inability to become sustainable due to a lack of investment in infrastructure and management. In many cases, the nonprofit is left with a few volunteers who shoulder much of the work. But what happens when these volunteers move on? The organization is left at risk.

There is a growing realization that not only are reasonable overhead expenses acceptable, they can also be critical to a nonprofit’s ability to function effectively and ultimately meet its mission. But how do we calculate overhead expenses?

Categorizing nonprofit expenses

Nonprofit expenses can be divided into three distinct categories: Program, administrative, and fundraising expenses. Program expenses are directly related to carrying out your nonprofit’s mission and result in goods or services being provided. For example, expenses to run a camp, deliver a class, put on a performance, allocate a scholarship, provide health care, or deliver food or clothing to the underserved are all considered program expenses.

Administrative expenses apply to the nonprofit’s overall operations and management. For example, the costs of board of directors’ meetings, committee meetings, general legal services, accounting, insurance, and bookkeeping. Fundraising expenses, on the other hand, include costs for promoting and conducting fundraising campaigns, maintaining donor lists, preparing acknowledgment letters, conducting special events, and any other activities that involve soliciting contributions.

So how do you break down your operating budget by category?

When categorizing expenses, the first thing you need to do is break out any expense lines that encumber all three categories, like staff expenses for example. If you have staff support for your organization, you need to break out the actual tasks by category.

Many nonprofits make the mistake of applying all admin costs to “administrative.” That would be incorrect. For instance, if the main purpose of your organization is to award scholarships and you have an administrative assistant who is managing your scholarship program, i.e., receiving applications, responding to applicants, securing missing materials, typing award letters, then these tasks would be categorized under “program.” If that same assistant is accepting and posting entries for your golf tournament, that would be categorized under fundraising.

There are no hard and fast rules

The IRS does not require that nonprofits spend any specific portion of their income on each category. It just wants nonprofits to report how they spend their money.

There is no single formula or ratio all nonprofits use to determine how much of their total budget should go to operating expenses and, as a result, you’ll hear all kinds of advice. The commonly accepted rule of thumb is that a nonprofit is doing well if overhead, or the combination of administrative and fundraising expenses, remains at 25% or less.

In fact, charity rating organizations grade nonprofits partly on how much they spend on overhead. For example, CharityWatch.com reports that it’s reasonable for most charities to spend up to 40% of their budget on operating expenses—in other words, at least 60% should go to programs, and 40% should go to everything else. However, charities that spend less than 40% get higher grades from CharityWatch, with those spending 25% or less on operating expenses receiving the highest “A” grades. Charity Navigator, which employs a sophisticated rating system, gives bonus points to nonprofits with lower operating expenses. The Better Business Bureau says that no more than 35% of a nonprofit’s budget should be spent on operating expenses.

Unfortunately, the desire to keep overhead costs as low as possible has had negative effects on many nonprofits. One study found that the lack of overhead investment has left many with insufficient administrative support, a lack of technology, inadequate office space, insufficient supplies, and staff members who lack the training they need to do their jobs properly. This “starvation” often leads to poor performance and an inability to meet the goals and objectives of the organization.

In addition, some nonprofits engage in accounting tricks to keep their reported overhead costs as low as possible—sometimes ridiculously low. A study of over 220,000 nonprofits found that more than a third reported no fundraising costs at all, while one in eight reported no management or general expenses. The researchers concluded that 75% to 85% of these nonprofits were improperly allocating their expenses.

The issue of nonprofits and overhead costs became so heated that several years ago the heads of the three leading nonprofit rating organizations--GuideStar, Charity Navigator, and BBB Wise Giving Alliance—created a website called The Overhead Myth. The website includes an open letter from the heads of these organizations denouncing the “overhead ratio” as a valid indicator of nonprofit performance.

In other words, the charity rating organizations recognize that nonprofits need to invest in the organization to produce successful results.

Evaluate the positive impact of overhead

Make no mistake, nonprofits are accountable to the community at large. But we are learning more and more that successful nonprofits will have overhead – administrative and fundraising costs. Rather than judging the worth and impact of a nonprofit by how little it spends on overhead, perhaps we evaluate how much impact this overhead ultimately has on the success of the organization and the ability of the nonprofit to address its mission. If kept to a reasonable level, this investment will no doubt come back to the organization in a big way.

Vicki Burkhart, CEO of The More Than Giving Company, presented “Categorizing Nonprofit Expenses” at a July 6 webinar during the Kids’ Chance of America 2020 Virtual National Conference.