What is Overhead? And Should Donors View It Differently?

Over the years, many donors have viewed a charity's overhead as a crucial - or even the only - measure of a charity’s worth and effectiveness. Experts have cautioned against this approach, advocating for a reevaluation of this metric in favor of a more comprehensive assessment of charities. Although overhead ratios are helpful in charity evaluation, they do not provide a complete understanding of the difference the organization is making. From costs beyond direct program expenses to the detailed classification of salaries and essential purchases, overhead is a complex concept that is frequently misunderstood.

What Overhead Is and Why It’s Essential

Overhead in the context of a charitable organization encompasses expenses beyond direct program costs. Overhead is what allows charities to function, grow, and thrive. Fundamentally, overhead is the backbone for crucial activities like fundraising, grant writing, human resources,  and financial accountability. These essential functions, made possible by overhead, allow charities to generate and account for the resources needed to provide impactful programming.

Misconceptions of What Overhead Is and Isn’t

Although commonly associated with administrative costs, including CEO salaries and fundraising expenses, there are more complexities on what is and isn’t overhead. For example, all salaries are often assumed to be overhead regardless of the position, but that's incorrect. When an employee at a charity dedicates their time to program delivery, the corresponding portion of their salary is appropriately categorized as a program cost rather than overhead. This is particularly true at small organizations where staff wear multiple hats; it is likely that even senior management dedicates at least some of their time to program delivery. Similarly, suppose a charitable organization makes a necessary purchase, such as acquiring a van for meal delivery. In that case, the expense is properly designated as a program cost, illustrating that overhead is a more nuanced concept than is commonly perceived.

Different Charities Need Different Amounts of Overhead

It’s also important to note that different types of charities will have different overhead needs, and some may require more or less overhead to function efficiently and impactfully. Their missions, stage of growth, and operational structures will dictate how much overhead is necessary to make the most significant impact. For example, the amount of overhead a large national charity needs will be different than that of a small, local charity. Also, some charities may need to invest internally to strengthen their programs by implementing new technologies or other support functions.  Whether it’s more or less, the role of overhead is crucial in charities’ success.  

How Overemphasis on Overhead Hurts: The Nonprofit Starvation Cycle

When donors lean too far into concerns about overhead, they inadvertently contribute to a detrimental cycle known as the nonprofit starvation cycle. This race to the bottom begins when organizations, in response to donors’ concern that overhead isn’t tied to impact, divert funds away from crucial support services such as accounting, human resources, fundraising, and infrastructure investments. Unfortunately, this shift negatively impacts the effectiveness of charities. Hiring and retaining top-quality employees becomes more difficult, lack of fundraising efforts reduces program budgets, and without investment in new infrastructure, charities may not be able to reach their next level of impact. 

As this cycle unfolds, the charity, in an effort to showcase a low overhead, inadvertently becomes a catalyst for a broader trend. Donors then use this reduced overhead figure to scrutinize and criticize other organizations, compelling them to follow suit and cut their overhead spending. This continuous downward spiral collectively weakens the entire social sector, ultimately diminishing the overall impact it could have on addressing critical issues.

How Charity Navigator Can Help You Find Your Way

You don’t want to contribute to the nonprofit starvation cycle, but you still need metrics to help guide your giving so that you can make donations with confidence. Charity Navigator offers a comprehensive perspective on charities, utilizing various metrics on impact, governance, transparency, financial responsibility, and leadership to paint a nuanced picture. A failing program expense ratio can be worth as little as 2% of a charity's overall rating, depending on the number of beacons it earns. 

While Charity Navigator emphasizes a preference for 70% or more of expenses to be directed towards programs, we don’t assign additional points for organizations with lower overhead. We see no evidence that a program expense ratio of greater than 70% leads to greater impact.  Balancing overhead with other factors ensures a more nuanced evaluation of a charity’s impact, allowing donors like you to donate confidently. 

Steps Donors Can Take to Make Informed, Impactful Giving Decisions

• Adopt a more comprehensive approach to evaluating charities beyond just overhead ratios. The nonprofit starvation cycle demonstrates the danger of over-emphasizing one factor in evaluation. It is convenient but insufficient to boil down a charity’s finances into a single ratio. 

• Consider the overall effectiveness, sustainability, and long-term impact of the organizations they support. Just like overhead is only one element of financial data, financials are just one piece of the charity impact equation. More comprehensive evaluation models, like our Encompass Rating System, can help you see the big picture.

• Prioritize alternative metrics and evaluation methods that focus on outcomes, transparency, and organizational capacity:

  • Impact & Results beacon: Cost per outcome metric

  • Accountability & Finance beacon: Liabilities to assets ratio and board independence 

  • Leadership & Adaptability beacon: Long-term planning and 

  • Culture & Community beacon: Beneficiary listening practices

     

Overhead is just one piece of the puzzle regarding determining how impactful a charity is. While donors can keep this figure in mind, balancing it with other factors and considering the broader context of a nonprofit's operations is essential. When donors prioritize a more nuanced understanding of overhead, there is immense potential for increased impact and positive change.