The obsession with indirect costs and the quest to find the perfect indirect cost ratio has sent foundations and other donors down a dangerous path. Those of us who manage organizations find it to be a meaningless metric. In fact, some of our favorite kinds of costs are indirect: investments in technology, talent development, benefits, evaluation, and fundraising, to name a few, are what enable the highest performing organizations to make incredible breakthroughs.
The indirect cost ratio is perceived to be a simple way for funders to understand whether a nonprofit is making efficient use of its dollars. Yet it’s folly to try to boil efficiency down to a single number. Understanding nonprofit finance is far more nuanced and contextual.
Years ago, when we developed a financial dashboard for our board, we included meaningful measures such as our liquidity ratio and months in cash. Then, we dutifully added an overhead cost ratio. Our board members, some of the most thoughtful leaders in the field of philanthropy, immediately made us remove it because it told them nothing about our organization’s financial health or efficiency. Furthermore, they told us, it could do harm by sending a subtle message to our leadership to avoid investing in our own effectiveness.
It’s broadly accepted at this point that efforts that rely heavily on overhead ratios to rate nonprofits are inherently flawed. Our sector needs to evolve. Some funders have already taken important steps toward providing appropriate financial support to nonprofits. Here are four things all funders can do to help the sector move away from obsessing over indirect costs.
- Get rid of caps on indirect costs. It’s time to leave the indirect cost ratio on the trash heap of misguided inventions, like trans fats and asbestos. The authors of “Pay-What-It-Takes Philanthropy” have done a fabulous job demonstrating why indirect costs are a problematic way of understanding whether a nonprofit is worthy of investing in. As they point out, “higher or lower is neither better nor worse.” Furthermore, “these figures are not measures of either effectiveness or efficiency.” We strongly disagree with the authors’ conclusion, however, that we need to develop industry standards by segmenting the sector and then setting benchmarks. Given that the indirect cost ratio has so little bearing on effectiveness or efficiency, studying it further won’t be of any benefit to the sector. There is actually an inherent risk in doing this—funders may be tempted to once again use it as a rationale for determining the “right” cap to place on indirect costs.
- Change the default setting in philanthropy to general operating support. We agree with the headline of the piece. Funders should pay what it takes. General operating support grants, oddly, get short shrift in the article. First, say the authors, nonprofits need to understand what “best-in-class execution costs to allocate general operating funds to highest-impact use.” We call foul. A well-managed organization understands exactly what it takes to deliver its key programs, regardless of the restrictions placed on its revenue. Operating grants give an organization flexibility to direct dollars to its highest impact activities and to change course when there are inevitable changes in the environment. Funders should start with the presumption that all grantees will receive general operating support funds and program grants must be justified. Program grants have their place, but these should only be in instances where you can’t reasonably make the case that the work of an organization directly fits the mission of the foundation. Program grants must, of course, cover the full costs of the program.
- Fund in other ways that support resilience. Funders need to get in the habit of making larger grants. We see many funders spreading their grants thin across many organizations in what has become known as “peanut butter philanthropy.” This forces grantees to raise lots of small grants from multiple funders, and translates into much higher fundraising costs for nonprofits. We’ve also noticed a tendency among some funders to make nonprofits take turns, because the thinking goes that it will prevent nonprofits from becoming too dependent. As a result, money doesn’t necessarily follow success. This actually makes high performing organizations less stable. A funder that spends more time analyzing which organizations are best suited to their goals, and less time managing lots of small grants, not only has a far greater impact on these organizations—it actually stands a chance of fully supporting the cost of the work it is funding.
- Help funders and nonprofits alike develop a deeper understanding of nonprofit finance. There are no shortcuts when it comes to understanding if a nonprofit is effective or financially stable. Groups like Nonprofit Finance Fund and GuideStar are developing meaningful measures of nonprofit financial health that help funders and donors get the full financial picture of an organization. An example is the Financial Scan instrument, which relies on a number of measures to understand a nonprofit’s finances.
It’s time to jettison the focus on indirect costs and stop sending a signal to nonprofits that they should scrimp on investments in what it takes to achieve high performance. Instead, both funders and nonprofits should spend more time understanding and investing in what it takes to succeed in the complex work of social change.