Indirect Costs

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Adapted from a 5-part series for the NAO eNews
Developed by Kay Sohl of Kay Sohl Consulting

  1. Starving Infrastructure: Damages, Effectiveness, and Sustainability
  2. Clearing the Cost-Allocation Fog: Defining the Terms We Use
  3. Six Ways to Fund Administrative and Overhead Costs

1. Starving Infrastructure: Damages, Effectiveness, and Sustainability

How much is too much for a nonprofit to spend on administration/overhead/indirect costs? Perhaps a better question would be how much is too little for a nonprofit to invest in infrastructure? Unfortunately, it’s a much less common question with some disturbing answers. There is a growing agreement between academics, the U.S. Government Accountability Office (GAO), and nonprofit leaders that underinvestment in infrastructure poses a serious threat to the effectiveness of nonprofit organizations.

GAO says it bluntly in its May 2010 report on the difficulty nonprofits have in getting the resources they need to invest in administrative and indirect costs: “A vicious cycle is leaving nonprofits so hungry for decent infrastructure that they can barely function as organizations—let alone serve their beneficiaries.”

The infrastructure starvation cycle involves three inter-related realities:

1. Charity watchdogs, the media, and government funders have long equated spending on administration and fundraising with waste and abuse, imposed arbitrary limitations, and encouraged donors to support nonprofits with the lowest administrative, fundraising, or overhead costs.

2. Among nonprofits, governmental and foundation funders, and the IRS, total confusion surrounds the definition of these dreaded overhead costs.

3. Nonprofit reporting of overhead costs is wildly distorted by both honest confusion and willful understatement, motivated by a desire to appeal to donors and conform to funder limits.

The result? Funder rejection of overhead costs combined with nonprofits’ desire to meet an unrealistic standard for minimizing investment in them damages both effectiveness and sustainability.

Are You Starving?
Are you starving your infrastructure? Here’s a quick quiz to jumpstart a more thoughtful examination in your nonprofit:

1. Do you know what you’re really spending on administration, fundraising, technology, client tracking, board support, and other key infrastructure functions? Or have you made these “hard to fund” costs disappear by not tracking the time all staff spend dealing with these systems, including downtime when systems fail?

2. If your nonprofit is small, how much time does your highest paid staff person spend on paying bills and keeping the books, fixing your technology, entering and retrieving data, and answering the phone?

3. If your nonprofit is larger, do your top managers have both expertise and time to plan effectively—integrate financial, program, evaluation, and fund development systems and provide the supportive supervision all staff need to work effectively?

4. Do you have (and can you retain) a Development Director with sufficient time and expertise to design a comprehensive fund development plan, identify and track key progress markers, manage donor retention, and cultivate new donors?

5. Do you have an exhausted Executive Director undertaking a never-ending quest for “work-life balance”?

Ready to break out of this defeating starvation cycle? Three steps will be essential: 1) understanding what you are actually investing in administrative, fundraising, and other overhead costs; 2) identifying the infrastructure investments you most need to build a sustainable organization; and 3) devising new strategies to fund your most significant infrastructure upgrades.

Resources


2. Clearing the Cost-Allocation Fog: Defining the Terms We Use

Before nonprofits and their funders can find a way out of the resulting destructive starvation cycle and have meaningful dialogue about how much is too much to spend on management or fundraising, we need to clarify the terminology we use, which creates a great deal of confusion.

Management/Indirect/Infrastructure
Unfortunately, nonprofits, government entities, and foundations use the same terms to mean different things and different terms to mean the same thing. Let’s start with one of the most maligned words—indirect. Foundation guidelines often prohibit funding for indirect costs. Direct federal awards won’t cover indirect costs without prior negotiation of a federal indirect cost rate. State and local government impose arbitrary limits based on multiple definitions.

The May 2010 report from the US Government Accountability Office concludes, “Inconsistencies in the use and meaning of the terms indirect and administrative, and their relationship to each other, has made it difficult for state and local governments and nonprofits to classify costs consistently.”

Nonprofits confront multiple definitions for management/administrative costs and confusing, and occasionally contradictory, requirements for how to compute them. GAAP and the IRS are pretty consistent in defining “management” as costs incurred for financial management, board support, organization-wide strategic planning, and the highest level executive management functions. Both are pretty clear that program direction and supervision are not “management” costs.

Indirect Costs
The fog starts to thicken with the introduction of the term “indirect” and gets almost impenetrable when “management” and “indirect” are treated as one and the same thing. The term indirect is best understood through contrast with the term direct. A direct cost is one that can be directly attributed to a specific function or purpose. For example, an organization offering senior, pre-school, and emergency services will know that the cost of employing a pre-school teacher is a direct cost of the pre-school program. In contrast, costs that can’t readily be attributed to a single purpose or function are deemed “indirect” costs. So if our sample organization houses all three of its programs in one leased facility, the cost of rent is an indirect cost—meaning that since we aren’t going to sign three separate leases, we’ll have to find a way to estimate the relative benefit each of the programs receive from being housed there.

Here’s the foggy reality. While the rent functions as a shared or indirect cost for conducting all three programs, it is not a management or administrative cost. In fact, in our example, there are no management functions housed in the facility. So why would anyone think of calling the “rent” an administrative or management cost? Because in some definitions of indirect costs, shared facilities costs are included in the calculation of indirect cost rates, along with the actual costs of management/administration. So when folks equate “indirect” and “admin,” suddenly the rent for program space is inflating the actual cost of management.

To further confuse the picture, consider the cost of the annual audit. It’s clearly a direct cost—a cost that can be directly attributed to the management function. However, the management function provides benefit to all other functions, both the different programs and fundraising efforts. And that benefit provided by management can’t be directly attributed to a specific program or fundraising functions. The result is that the whole management function must be treated as an “indirect” cost, and we must estimate the relative benefit provided to each program, as well as fundraising.

What Are You Talking About?
Where all this leads us is that when one nonprofit talks about its indirect costs it may be talking about all costs that can’t be readily attributed to specific functions—facilities, telephone, and reception, as well as management costs. Yet a different nonprofit may be talking about only its management costs. Still another nonprofit may regularly insist it has no indirect costs because it doesn’t ever gather its shared costs into a cost center or pool and instead applies an estimated formula to each individual cost item—for e.g., dividing up the audit cost and allocating it to various programs and funding sources.

Lifting the Fog
How can you get the fog to lift for your organization? Start by creating a functional budget with clear cost centers for management, fundraising, and each program area. Enter all the costs that can readily be directly attributed to a function/cost center into the correct cost center. Decide how you will treat the non-management shared costs like rent, telephone, etc. One way is to create an indirect or shared cost center for them. Another way is to document the allocation formulae you’ll use to estimate the relative benefit of each of these costs to each functio—e.g., percent FTE or percent of direct costs assigned to each function—and then allocate the shared costs using your formulae.

If you choose the non-management indirect cost center method, you’ll need to identify a way to allocate a share of the total indirect cost pool to the various program, management, and fundraising cost centers. If you want to figure out the full cost of delivering each of your programs, you’ll also need to allocate the total in the management cost center as well. However you handle the allocation challenges in your budget, you will want to use the same method in your accounting system so that you can compare what actually happens to what you planned in the budget.

Of course clearing the fog in your own organization isn’t the end of the story. Communicating your costs to a world lost in definitional fog and paradoxical thinking is a much bigger challenge.

3. Six Ways to Fund Administrative and Overhead Costs

Funders, charity watchdogs, and unfortunately some nonprofit board members, are trapped in the type of paradoxical thinking that leads to the infrastructure starvation cycle. They seek to support nonprofits that achieve the highest standards for accountability, transparency, and diversification of financial support, while simultaneously insisting that the “best” nonprofits are those that spend the least on the management and fund development capacities that are essential to achieve those results.

The folly of the paradox is intensified by utter confusion about the definition of management and fundraising costs among governmental agencies, private funders, and nonprofits. The sustainability of your organization depends on finding strategies to support the core capacities needed for effective operation and resiliency.

Here are six strategies nonprofits are using successfully to fund administrative and overhead costs.

1. Negotiate Fully-loaded Cost Agreements
Be sure your proposals for funding include a fair share of your administrative and overhead costs, as well as the direct costs of providing your programs and services. The rationale here is that achieving the results funders want will require your nonprofit to employ staff, process payroll, keep accurate financial records, have effective board oversight, etc. You will want to be sure those staff can work inside with heat and lights. Your budget proposal needs to include the full cost of achieving the desired results.

2. Pursue Performance-based Contracts
Urge your funders to base payment on the results you achieve rather than the costs you incur. Agree to take the risk that it may cost you more than the funder will pay to serve the agreed upon number of eligible people and provide acceptable services, in return for having the opportunity to retain a financial reward for achieving the required results at lower costs. Before you move in this direction, you will need clear information about your fully-loaded costs and effective systems to make sure you achieve your target volume of services.

3. Make Overhead Costs Disappear
Allocate the shared costs of rent, utilities, phones, and even the costs of management, on a transaction by transaction basis—avoid listing any costs as “overhead.” This approach has numerous potential pitfalls, including failure to adjust your allocation formulae when you add or drop programs and reinforcing the erroneous idea that good nonprofits don’t have overhead costs. But it may offer a survival strategy while you work on the other strategies.

4. Capacity Building Grants
Larger foundations, and funders who have a history with you, are often open to investing in strengthening nonprofit capacity—including upgrading accounting and client tracking systems, developing meaningful evaluation approaches, expanding individual donor development efforts, and improving communication with potential donors and volunteers. Caution: successful proposals require demonstrating that you will be able to sustain the new systems and capacities and achieve better results after the grant funds are exhausted.

5. Invest in Your Own Capacity Building
If lack of capacity for management or fundraising is resulting in inefficient use of staff resources or missed opportunities to strengthen donor relationships, consider strategic investment of a portion of your reserves. Caution: prepare as compelling an analysis for the use of your own funds as you would for a request for foundation support for capacity building. Identify critical progress indicators and commit to making changes if your strategies are not achieving your targets.

6. Ask Your Closest Donors to Support Infrastructure
Current and former board members and your largest donors love your organization. It’s quite likely that they already understand how important effective management and productive fund development is to your ability to achieve your mission. Consider asking those who care the most to be part of the solution by making special gifts for specific capacity building projects or to a campaign to establish an endowment to provide ongoing support for infrastructure.

Be Part of the Solution
Join the Nonprofit Association of Oregon and participate in its efforts to build public understanding of the impact of the nonprofit sector and the need to invest in infrastructure to ensure sustainability. Discuss the starvation cycle and your organization’s strategies to avoid its traps as part of your next strategic planning effort. Encourage your board members to speak up about the reasons they are committed to your organization—and notice how rarely the percentage of expenses devoted to infrastructure makes their top 10.

The Nonprofit Fiscal Managers Association is an excellent resource for training on these and related topics. To receive announcements about the various nonprofit network sessions and related workshops, please update your mailing preferences.