...and why does it matter?
This set of FAQs provides a brief introduction to the topic and the controversy.
What's the definition of "overhead" anyway?
In everyday conversation, nonprofit overhead is a fuzzy term meaning administrative costs such as accounting, insurance, and the salaries of administrators. People understandably don't want nonprofits to have too many pencil-pushing bureaucrats.
Unfortunately, even in ordinary conversation, people mean different things by "overhead," and there are different terms in accounting and in regulations. There is no consensus about which definition is "right." Some accounting terms which are similar to "overhead" and often confused with it are:
- Indirect costs
- Administrative costs
- Shared costs
- Fixed costs
In fact, in one study respondents were asked which of the above was the closest synonym to "overhead," and no one choice received more than 40% of the votes. In short, any two people talking about overhead are statistically likely to be talking about different things without realizing it.
So then how is nonprofit overhead calculated?
Outside of calculating overhead to conform with specific government guidelines, the most common method is to rely on information from federal Form 990, the form which nonprofits are required to submit annually to the IRS.
On Form 990 all expenses must be classified into three types:
- Program Services expenses
- Management & General expenses
- Fundraising expenses
Overhead is calculated by adding Management & General expenses to Fundraising expenses, then dividing by total expenses.
For example:
- Program Service $80,000
- Management & General $15,000
- Fundraising $5,000
- Total $100,000
Management & General + Fundraising = $20,000.
Divided into $100,000, the overhead is 20% of the total.
That seems pretty simple!
Yes! Unfortunately, though, the terms "Management & General" and "Fundraising" are often misinterpreted -- sometimes intentionally but more often mistakenly. In a simplified example, imagine an organization with three staff that 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%.
It's also true that a dishonest nonprofit can choose to categorize nearly everything as "Program Services," when in fact some of those expenses truly are either Fundraising or Management & General.
How can "Fundraising expenses" be complicated?
Some fundraising expenses are easy to classify, such as the expense of sending a solicitation letter or hiring a grantwriter. Others are more complicated.
In an example that illustrates some of the nuances of Fundraising expenses, imagine an executive director speaking at the local Rotary Club. Is the time spent a Program expense -- because it is educating the public about autism, let's say -- or is it Fundraising -- because the talk included an invitation to attend an upcoming luncheon?
Where did the term "overhead" come from?
In the early days of manufacturing, one way to think about costs was to classify them into three categories:
• Materials
• Labor
• The building "overhead" in which manufacturing took place.
The cost of the building was a fixed cost -- it remained the same regardless of how many products were made. The cost of the building was also a shared cost -- a portion of it has to be recouped in the price of each item sold.
So is overhead bad? Or good?
Overhead is necessary, but there can be too much or too little. For example, if a factory spends all its money on its building but buys shoddy materials and hires untrained workers, it will not make good products. At the same time, if the factory buys good materials and hires skilled workers, but doesn't spend enough on overhead, soon the roof will be leaking and the electrical systems will be failing.
In community nonprofits, it's far more common for nonprofits to underspend on overhead. A closer look at overhead shows that it includes necessary expenses such as rent, utilities, insurance, accounting costs, and administration.
But nonprofits aren't factories. What are some typical nonprofit overhead expenses?
Think of overhead expenses as those that are not easily identified with one program, but are necessary to all programs. In this sense the term "overhead" is closest to "indirect costs."
For example, imagine a community theatre that produces plays and also conducts after-school drama workshops for high schoolers.
Some expenses are clearly those related to plays, such as the artistic director's salary, the cost of actors, costumes, props, and so forth. Other expenses are clearly related to the drama workshops, such as the cost of teachers and workshop materials.
But other costs are shared costs, such as
- Insurance
- Building maintenance
- Utilities such as electricity and internet
- The audit, accounting staff, and fundraising costs.
Play production direct costs: $600,000
Drama workshops direct costs $300,000
Indirect costs $200,000
Total $ 1 million
In this instance, the $200,000 of indirect costs is 2/10ths of the total costs, so the nonprofit has an indirect cost rate of 20%.
This seems pretty straightforward. What's the controversy?
All of us know that some overhead is crucial, but that it's also possible to have too much overhead. So the controversy is about: how much is too much and how much is too little?
- Oregon recently passed a law taking away tax-exempt status for nonprofits that spend more than 70% on overhead
- One study of the public showed that the public believe that 23% is "reasonable" while at the same time believing that most nonprofits spend 37% on overhead
www.greymatterresearch.com/index_files/nonprofit_overhead.htm - Foundations often allow 10% - 15% overhead in grants (if they allow overhead at all)
www.ssireview.org/articles/entry/the_nonprofit_starvation_cycle - Government contracts with community nonprofits often range from 0% to 3% to 25%
- As a comparison, Harvard's indirect cost rate is 68% while Iowa State's is 48%.
- Among the online charity raters, Charity Watch gives poor ratings to nonprofits with 40% or higher overhead rates; Better Business Bureau uses 35%, and Charity Navigator does not disclose their protocol.
With these differences, many nonprofits have to report 11% overhead to one funder, 3% overhead to another, and perhaps 40% to yet a third. (Yikes!)
But more importantly, the confusion over overhead has resulted in overall under-funding of necessary overhead costs, and a result, under-spending on keeping the roof in good repair, on adequate accounting, on internal systems, on staff training . . in short, under-investment in the financial sturdiness of nonprofits.
In addition, some efforts take more overhead than others. For example, at the beginning of the environmental movement, the public didn't understand the idea of cleaner air or water, so if was more expensive to raise money than it later became. Some causes are simply harder to raise money for than others. Higher fundraising costs may not mean the nonprofit is less capable or hardworking.
So...the controversy is about "too much" and "too little" but it's hard to define overhead exactly?
Exactly! That's what the Nonprofit Overhead Project is all about:
- Helping nonprofits calculate overhead properly
- Streamlining and strengthening government-nonprofit contracting
- Supporting foundation and donor conversations about overhead
- Helping nonprofits communicate overhead concepts
- At the heart of all of this: obtaining fairer funding of indirect costs which will support nonprofit sustainability, network sustainability, and quality and quantity of services to communities.
