It’s a vicious cycle. Almost every nonprofit organization knows it well. Common misconceptions fuel the belief that a healthy nonprofit is performing as it should only when overhead costs are as minimal as possible. Donors look for lean nonprofits, and organizations end up starving operation budgets to meet investment expectations and requirements. The result? Nonprofits do not make strategic investment decisions with their money. Instead, they end up starved of the resources necessary to run a successful organization.
This phenomenon is called the “nonprofit starvation cycle,” after the title of a famous paper by the same name, published in 2009. The authors of the paper expose this vicious investment cycle caused by this “overhead myth” that an organization’s overhead budget should be minimal for it to be effective. When donors consider an organization only as the line items on its budget, they miss the key indicator of nonprofit success — impact.
The Idealistic Investment Cycle
What causes this cycle? For the most part, a mistaken viewpoint. The paper discusses the common view within the nonprofit sector that organizations should have an overhead budget below 20 percent of the total yearly budget. That means an organization should spend less than a fifth of their budget on operations, finances, human resources, fundraising, IT, and all other non-program related activities. All parties — nonprofit executives, foundations, and donors — hold to this belief, but it is not realistic. By comparison, the authors use Standard and Poor’s data to show that the average company has overhead costs of 25 percent, and in the service industry, which more closely resembles the nonprofit sector, no company reports spending less than 20 percent on overhead. As a small sample, the authors studied four nonprofits that all had overhead budgets between 17-35 percent. The real cost of running a nonprofit is more than both funders and nonprofits expect.
This lack of realism makes the investment cycle destructive. Funders with inaccurate expectations look for organizations that fit their image of the optimal nonprofit budget. Consequently, organizations reporting more than 20 percent overhead run a grave risk of scaring away potential donors and foundations. Awarded grants are also poorly structured. The authors found that government grants on average only allowed 15 percent of the money to be spent on overhead. Foundations were worse, only allowing 10-15 percent. These grants often come with reporting requirements too, meaning that nonprofits are required to spend money to track data showing that grants are spent properly. And, it’s expensive. In a survey by Grantmakers for Effective Organizations, only a fifth of the 820 foundations surveyed believed that grants covered the demanded expenses. These requirements make it difficult for organizations with standard overhead costs to win grants and then properly administer the grants once they are awarded.
To meet donor expectations and compete for funds, nonprofits often skew numbers to fit preconceptions. The four sample organizations studied by the authors had overhead budgets between 17-35 percent, but they reported an overhead budget between 13-22 percent. This misreporting might be surprising, but it’s also common. In the Nonprofit Overhead Cost Study, researchers analyzed 220,000 budget reports and found that one in three organizations did not include a fundraising budget, and one in eight listed no management or general expenses. The incomplete numbers help organizations meet reporting demands, but they falsely confirm incorrect donor expectations and make it more difficult to correct those demands in the future.
Nonprofits go beyond trying to meet donor demands on paper. Managers attempt to keep costs down by limiting their investments within the organization as much as possible. In the Nonprofit Overhead Cost Study mentioned above, researchers looked at organization infrastructure like computers, staff training resources, and even furniture. The results are predictable — computers did not work, staff was not properly trained to perform tasks, and in one case, the furniture was so worn down that movers refused to touch it. These are not just cosmetic issues. Failure to invest in IT systems and training results in more time spent inputting data in insufficient systems, and less effective social programs.
The cumulative effect of the starvation cycle is that organizations feel the need to slim down as much as possible on paper and in practice, and funders use unrealistic numbers to determine who receives an investment and how they can spend it. Too much energy is wasted on the wrong goals and not enough is achieved.
The Impact of Strategic Investment
Since the consequence of the starvation cycle is less effective nonprofits, the sensible solution is to focus on improving impact. The authors suggest a two-fold solution. First, instead of using inaccurate ratios, they recommend determining whether the organization is succeeding at its mission. Given the stated aims of the nonprofit, is there evidence suggesting that its social programs have the intended effect? Second, what funding is necessary to ensure that they do? For donors’ money to make the biggest difference, they need to invest strategically.
The turn to strategic investing creates the greatest opportunity for nonprofits to make an impact in their communities. It is common knowledge within the business community that a given amount of money yields a vastly different return on investment depending on where it is spent. This holds true in the nonprofit sector as well. Applying a strategic, economic approach to investment and allocation of resources helps nonprofits maximize impact, just as it does for-profit businesses. Some nonprofits should invest in an upgraded IT system to improve data measurement and provide better communication delivery. For others, a new physical location can provide constituents far greater access to services. The best use of resources can look different for each organization, but the economic thinking remains the same. Because resources are so limited in the nonprofit sector, an investment mindset is even more critical.
This is why we take a venture philanthropy approach. Stand Together Foundation invests substantial time meeting with potential partners before moving forward. Those discussions allow for honest conversation about each organization’s current needs and growth plans. Only after that takes place can we tailor our investment to make the biggest difference. We have found that the best way to break the starvation cycle is to establish a partnership that extends far beyond the time, talent, and funds that are transferred. It is a collaborative approach to investment, working with each partner to ensure that our financial resources and expertise are utilized to their greatest potential. The time spent learning has never been wasted.
Korey Mauer is an engagement associate at Stand Together Foundation, where he assists partners to overcome business challenge and achieve increased growth and organizational impact. Korey earned his B.A. in philosophy from Grove City College and his M.A. in philosophy from Western Michigan University, where he taught undergraduate classes. In his spare time, Korey enjoys urban exploration with his wife Clarissa, reading just about anything, and following the shenanigans of the Detroit Lions.