Another article on donated meds and overhead ratios – the impact of substitution on our thinking process

An Op-Ed in the Los Angles Times by Jack Shakely, president emeritus of the California Community Foundation, discusses the impact of donated medicines on the functional allocation:  The worst way to judge a charity.

A friend of his was grouching about another NPO buying meds for $0.10 a pill and booking them as GIK revenue at $7.00.  Mr. Shakely looked at the organization’s web site and found they claim 90% of the contributions go to program, with 5% to G&A. That leaves 5% for fundraising.

He then wonders why we are putting so much emphasis on the functional allocation as the main measure of an NPO.

In large part, that emphasis comes from funders. He says it’s:

Because low administrative costs are the holy grail in judging how well a nonprofit does its work. It’s not the only thing responsible raters look at, but it’s the shorthand.

The problems with this approach? He explains:

Don’t get me wrong. Low administrative costs could indicate prudence and sound judgment at a charity, but they could just as easily indicate inadequate staffing, insufficient salaries or, shall we say, fudging. Moreover, administrative costs aren’t the primary measurement of for-profit excellence. Are McDonald’s admin costs lower than Wendy’s? Apple’s lower than Microsoft’s?

I discussed the underfunding of infrastructure to improve ratios, otherwise know as the starvation cycle, at my post “Nonprofit Starvation Cycle.”

Saundra Schimmelpfennig discusses the challenges of interpreting the functional allocation in her e-book, Lies, White Lies, and Accounting Practices; Why nonprofit overhead doesn’t mean what you think it means.

I described that book in my post Q: Are overhead ratios the perfect measure of NPO efficiency and effectiveness?


Mr. Shakely contributes greatly to this discussion.  Why is there such emphasis on overhead ratios?  He expands the discussion to include the troublesome psychological concept of substitution that can distort our thinking:

Daniel Kahneman, the Nobel Prize-winning economist, in his brilliant new book “Thinking Fast and Slow,” calls it substitution. Each of us, Kahneman writes, has in effect two systems of thinking — an intuitive system that we rely on for quick answers, hunches and gut reactions, and a rational, statistics-driven intellectual system.

Because it is hard work to figure out if an NPO is effective or even if it is reasonably efficient, we grab hold of the overhead ratio found in the functional allocation disclosure and assume that number is the measure of efficiency and perhaps even effectiveness.

Not a logical analysis as both Ms. Schimmelpfennig and Mr. Shakely point out, but it is close enough that many of us run with it.

The error in that thought process is substitution.  There are two specific mistakes. First, effectiveness can not be measured by an efficiency measure.  They are two different things.  Second, the reported overhead ratio found on the functional allocation may or may not be an accurate efficiency measure. It depends on the good intentions & motivation of management and the astuteness of the auditor.

The functional allocation is a good, useful tool to evaluate NPOs.  But we need to remember it is only one tool.  Ms. Schimmelpfennig and Mr. Shakely remind us that sometimes it can be a broken tool.

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