What Nonprofits Should Know About Overhead

Tuesday, March 23, 2021

Discussions of nonprofit organizations and finances can quickly become murky because so many people simply do not understand that nonprofits still deal with money. In fact, they’re at least as aware of it as their for-profit peers. One area in which nonprofits sometimes struggle is in knowing how to approach and deal with overhead.

If your organization struggles to sell the concept of overhead to donors who delight in offering money for the more “meaningful”, this one’s for you!

The cost of service

Doing the work of your organization takes dollars, and that extends beyond the actual money you use for the flashier aspects of service. Indirect costs make the magic happen, even if they aren’t as easy to sell. The money it takes to operate a nonprofit organization, also called overhead, is an essential consideration for nonprofit budgeters.

Any money spent on things like management, administration, and general costs fall into the overhead category, and these can vary greatly. From paying business consultants to training staff, overhead costs are many. Generally, you can categorize overhead into a few categories, which include indirect costs, administrative costs, shared costs, and fixed costs.

How overhead is calculated

Calculating overhead, like most things in the nonprofit world, is accompanied by a set of rules. Most nonprofits calculate overhead from information gathered from federal Form 990, submitted each year to the IRS. Form 990 categorizes a nonprofit’s expenses into three categories, which are Program Services, Management and General, and Fundraising. By adding Management and General expenses to Fundraising and then dividing by total expenses, you reach an official overhead cost.

Where mistakes happen

Although this formula is fairly simple, people make mistakes regarding how to categorize certain expenses. Things get incorrectly lumped together or carelessly combined, resulting in inaccurate calculations. An example of this might be employees who attribute their time Program time to Admin time, etc. If you aren’t paying close attention, it can be easy to under or overestimate your actual overhead.

When we’re talking about fundraising expenses, there is even more room for error. In the course of offering services, a nonprofit might issue an invitation to a fundraising event. Does this qualify as a program cost? Or is it fundraising? Likely, it is a program cost, but a misattribution can make overhead seem much higher.

Why does it matter?

All organizations, whether for profit or nonprofit, must have overhead. Of course, finding the right balance is key. If a nonprofit spends most of its dollars on a luxurious office far away from the population they serve, it might raise a few eyebrows. However, if a nonprofit frequently reports absent employees because of a recurrent mold problem in their basement office, you’ve also got a problem. Learning to manage your nonprofit budget ensures that your overhead falls exactly where it should. Most nonprofit organizations actually underspend on overhead, but being aware of what it is and how you’re managing it is crucial to your continued success.

Common types of overhead for nonprofits

Although each organization is different, there are some common types of overhead that you can probably expect to see within your nonprofit. If you rent or own office space, it is obviously overhead. But so is insurance, maintenance for your building, utilities, internet, staff, independent contractors, accounting staff, and costs associated with fundraising.

Too much and too little

Especially in the nonprofit world, there’s a lot of talk about too much and too little, and this definitely applies to overhead. In some states, too much overhead will even revoke your nonprofit status. For other nonprofits, the public perception of high overhead damages their reputation and discourages potential donors from writing those checks. Charity watchdog organizations and even the Better Business Bureau can also raise or lower an organization's ratings and rankings based on overhead. This is a tricky area because there is no exact right formula for overhead costs amongst nonprofits, since there is such a range in size, location, and services.

When overhead is a good thing

While supporters understandably want the bulk of their donated dollars to go toward service, overhead costs can signify a well run organization that treats employees well and effectively manages a business. It is often said that you’ve got to spend money to make money, and that is even true in the nonprofit world. Organizations that manage overhead (but still have it), often are better run, have happier employees, and turn those dollars into more dollars that help the community in bigger, substantial ways.

Instead of looking at overhead and questioning an organization, it is useful to shift our thinking to identify how well a nonprofit (or any business, really) turns overhead into services. If things are working efficiently, even a high dollar overhead will make up a very small percentage of money coming in.

The cost of too little

In an article published in Stanford Social Innovation Review, writers Ann Goggins Gregory and Don Howard referred to a focus on extremely low overhead as the nonprofit starvation cycle, noting that it leaves nonprofits “so hungry for decent infrastructure that they can barely function as organizations–let alone serve their beneficiaries.

Indeed, the fear of overhead can often lead to nonprofit organizations that don’t last, which is the last thing we want. Low overhead can result in employees who lack training, workspaces that are unsafe and unpleasant, and computers that can’t accurately meet the needs of the people they’re meant to serve.

This cycle often begins with unrealistic expectations about how much it costs to run an organization, followed by spending too little, and finally, underreporting expenditures to meet the unrealistic expectations of founders. Gregory and Howard suggest that the cycle can be stopped by simply managing expectations about what it costs to run a nonprofit in the very beginning.

The lasting results of low overhead

Extreme caution over managing overhead can lead to drastically underfunded organizations, which often ask too much of employees, who are then quickly taxed into finding a different, less demanding job. High employee turnover is expensive, which leads to–you guessed it–higher overhead costs.

What does it all mean?

Overhead is obviously important, and understanding how it operates within your organization is essential to your success. When you can effectively identify, define, and manage overhead, your nonprofit stands a greater chance of flourishing. With streamlined services that operate efficiently, your overhead becomes more manageable, which is the goal.

But how exactly can a nonprofit do this? It doesn’t have to be complicated.

The path to managing overhead

Lower overhead keeps nonprofits in better standing with the government and community, but it also allows more money to go toward the heart of the nonprofit, which is the services it provides. Imagine if more dollars every single month could go toward those causes–the difference an organization could make becomes limitless.

Check your calculations

Your first step to managing overhead is to make sure that you’re calculating things correctly. Consider a formal policy or handbook that helps define what overhead is and how common things within your organization should be categorized. Set clear rules, and reach out to a nonprofit expert if you aren’t sure about something. Begin your shift toward lower overhead by truly understanding the among of overhead you’re dealing with in the first place.

Open up the conversation

Two brains are usually better than one when it comes to new ideas, so don’t hesitate to get your employees and board members involved in brainstorming ways to reduce or more effectively use overhead. They may be connected to a service provider who can offer a lower rate, know an expert who will increase the speed of a particular operation, or know a cool trick that keeps electricity costs down.

Learn how to communicate

No matter your overhead, you’ll need to be able to effectively tell the story of why your nonprofit spends what it does. Figure out how you can present your expenses in a way that emphasizes their importance to your organization and the services you’re able to provide. Set people up for lasting success by clearly communicating the true cost of running your organization from the very beginning.

A better way to evaluate nonprofit performance

Finally, know that, while looking at overhead is a seemingly easy way to determine how well a nonprofit is doing or whether or not a person’s dollars should find a home there, it isn’t a great way to evaluate nonprofits. Instead, nonprofits should be evaluated based on more complex data, including reach, overall performance, cause you care about.

There are also a breadth of organizations designed to help donors sort through the huge variety of nonprofits out there, and if you’re working for or with a nonprofit, you’ve likely heard of some of them. These include, but certainly aren’t limited to:

• BBB Wise Giving Alliance
• GuideStar
• Charity Navigator

Each of these organizations evaluates nonprofits based on more complex criteria that should give donors and communities a better look at the work they’re doing. Alternatively, a person could simply reach out to an organization to find out more about them and determine whether or not that particular nonprofit is the type of organization they’re looking for.

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