While corporate giving officers rightly seek to support those nonprofits that are effective and efficient with grant funds, using the common metric of overhead cost ratios to assess their effectiveness is unreliable, at best, and may be harmful to the sector as a whole, according to researchers at Texas A&M University.
In a study published in IZA World of Labor, associate professor of economics Jonathan Meer found that relying on overhead ratios causes nonprofits to spend less on administrative expenses—most notably, staff salaries and benefits.
This is a problem because paying wages that are low relative to similar jobs in the private sector means that the most talented workers are unlikely to choose to work for charities, Meer found. While lower pay might be offset for some nonprofit staff by way of a feeling of “doing good” and contributing to a cause they believe in, that only goes so far in limiting the talent drain, Meer said, because it generally only applies to those on the front lines—the case workers and others directly involved in providing services to constituents. Other employees—such as the organization’s IT workers, or HR and accounting staff—tend not to experience the same level of personal satisfaction from helping the less fortunate. The result of this, Meer said, is that the nonprofit sector is often stuck with lower-quality workers in important support positions.
The solution, many argue, is for donors to allow for higher percentages of their donations to go to overhead, and to eschew overhead ratios generally as a way of selecting nonprofits to support.
Another approach would be for funders to specifically allocate grants to the kinds of administrative and back-office functions that nonprofits need but are leery of spending much on due to their impacts on overhead. For example, directing funds to professional accounting and auditing services, and training employees throughout the organization on sound financial management and oversight practices, would be a wise investment, not just in terms of helping charities pursue their missions, but also in avoiding the kind of fraud and financial blunders that have hobbled several high-profile nonprofits in recent years.
According to Adam Cole, co-leader of the Nonprofit & Education Practice at accounting firm BDO, instituting some sound accounting and management practices is key to avoiding both financial mismanagement and fraud.
“Good governance and hiring competent auditors can avoid most of these problems,” Cole said.
Cole and his firm have seen firsthand the impacts of poor financial controls in a nonprofit. Whether it’s small-dollar theft of a few hundred bucks—likely to go unnoticed in an organization with a budget that runs in the millions—or a sudden liquidity crisis that brings to light mismanagement on a much larger scale, nonprofits of all stripes are vulnerable, he said.
The impact goes far beyond just the dollars involved, due to the hit on an organization’s reputation.
“Even the small-dollar examples can be quite embarrassing and harmful to the organization,” Cole said. It might be only a few hundred bucks but if it makes it into the papers, that’s what people see—the group’s name tied to a scandal.
Of course, the best way to deal with such scenarios is to avoid them in the first place. For that, Cole says following good financial management principles is critical.
Some relatively simple steps include dividing fiscal responsibilities between multiple staff members—so that one can be a check on the other—and ensuring that there is adequate oversight for anyone responsible for cutting checks and keeping books, whether that’s the executive director or the board itself.
Another thing to keep in mind is what’s called the fraud triangle—opportunity, justification and pressure—that is often at the center of fraud cases. Where someone sees opportunity, and can rationalize breaking the law, all that’s left is pressure—usually in the form of financial woes that the organization might have seen coming via a background check prior to hire, something Cole highly recommends.
Further, investing in a good financial accounting and auditing firm can catch any goings-on quickly and keep the financial and reputational costs to a minimum.
All of these things cost money, yet don’t impact the number of constituents served—thus pushing up the dreaded administrative cost ratio and making it appear on paper that the organization is less efficient than another charity without such controls in place.
But funders that can look past that will see the value of an organization expending the resources needed to ensure sound financial management—and the wisdom of funding it directly.