Two more cautions on how to interpret overhead ratios

Came across two more articles reminding us to be careful in how we use overhead ratios to assess nonprofits. The functional allocation is a useful tool but needs to used and interpreted carefully.

Meaningless Fractions is a guest post at AidSpeak from Fredrick.

His concern is that the way overhead ratios are emphasized creates confusion between inputs and outputs. Overhead is one of many inputs. Delivering aid requires a wide range of inputs. In addition to infrastructure, an organization needs skilled people in the right locations at the right time, corporate knowledge of how to deliver effective aid, and dozens of other inputs.

Mr. Fredrick uses this illustration:

It is like a farmer bragging about using as much as 90% of the total of cost running a farm on fertilizer and only 10% on seeds. Who cares? What you should care about is how much the farmer produces for a given cost.

He checked with some aid agencies about what their overhead ratios mean and why they are emphasized. What did he find?

The answers were quite depressing. The numbers were acknowledged to be meaningless. But it looks good for potential donors that a large fraction of their money isn’t “wasted” on administration, so the numbers are basically reproduced for marketing purposes.

He then provides one example of counterproductive behavior which seems to be driven by the need to manage the overhead ratio down.

Mr. Fredrick wishes to remain anonymous. He does provide a photograph on his bio. It is a photo of the tail end of an elephant.  I guess that would be where we could find the elephant’s output.

(Since this post is in written form, I guess I need to mention the previous sentence was said as a whimsical joke since you didn’t hear the chuckle as I typed it.)

Mr. Jonathan Ferguson explains overhead rate is a poor measure of efficiency at the NFP Audit and Accounting blog.

He explains the irony that if the overhead ratio is the only important metric, then it would be advantageous to be inefficient in spending program dollars – buying from the highest priced vendor will improve your overhead ratio. Likewise, it would hurt the overhead ratio if the program could somehow arrange volunteers to effectively do the work that previously paid staff were doing.

Mr. Ferguson says that is obviously a stretch, but that’s the adverse motivation created by over reliance on the functional allocation.

He points out something I’ve noticed for a very long time – overhead ratios vary tremendously based on the type of organization.

Organizations with a large GIK component to their ministry often have very low overhead rates due to the value of the goods they distribute. Child Sponsorship organizations tend to have higher overhead rates due to the additional administrative effort required to connect each sponsor and child. … Grant funded organizations tend to have overhead rates which fall in the middle. In other words, the type of donations received can have a bigger impact on overhead rate, than the quality of an organization’s management.

The lesson here? Don’t compare the overhead ratio of a relief and development agency with a child sponsorship organization. Likewise it would be a bad comparison to look at the ratios for an NPO working in a socially popular, politically neutral cause with an NPO that is addressing a politically divisive and unpopular cause. Fundraising is easy for the first organization while the second organization has to spend a lot of extra time raising funds.

Three closing ideas: The functional allocation has value. We need to be careful when we compare NPOs in different sectors. We somehow need to use more tools than just the overhead ratio.

Mr. Ferguson has an eloquent conclusion which makes those three points:

So, what should we be measuring? There is clearly need for comparisons among not-for-profits. There are also benefits from these comparisons both for donors and management. But there are clear flaws in overhead as the comparison tool of choice. I think it would be wise to evaluate similar types of not-for-profits based on a grouping by mission (for example Relief & Development, Conservation, Medical Research, etc.). For each grouping an efficiency measure could be determined by dividing total costs by a common outcome metric. For example, animal shelters could report costs per animal served. Then efficiency could be better gauged for similar organizations.

I also think that breadth of analysis can be a solution as well. Part of the problem with overhead is that it is often viewed as the defining, authoritative metric. If other metrics are considered as well (unrestricted undesignated net assets, growth rate adjusted for organizational size, liquidity, etc.) a more complete and useful comparison emerges.

Check out both articles. They each contribute to the discussion of how to interpret the overhead ratio.

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