What's a good indirect cost percentage?

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Cover Story

100% Goes to Charity?

A practical and philosophical look at what it takes for a nonprofit to

deliver services.

by Lee Draper

The

Los Angeles Times

proclaimed “No

administrative fees means all money goes to

local charities” when it launched its 2002 holiday

drive to raise funds for community services.

When the September 11th Fund was created by

the New York Community Trust and the United

Way of New York City a little more than a year

ago, ads repeatedly emphasized that 100

percent of all donations would go directly to the

victims of the terrorist attacks.

The American Red Cross’s Liberty Fund labeled

its fundraising for the same purpose with a “100

percent goes to charity” banner.

There are countless other occasions when

donors and nonprofit organizations similarly

assert this intention to focus

all

contributed

resources on direct services or programs.

But how can this be done?

Does the claim of “100 percent goes to charity” establish unrealistic

expectations?

More important, is this approach a truly beneficial way to deliver services to

fill vital public needs?

Erosion of Trust

It seems that few people stop to question how the

Los Angeles Times

could

raise hundreds of thousands of dollars from a holiday appeal and then

allocate the sum to charities throughout Southern California with “no

administrative fees.” Nor was there much concern expressed out loud

about how the New York Community Trust and United Way of New York

City would finance the cost of processing the $500 million in donations from

all over the country, the cost of investigating requests for funding from

hundreds of individuals or the cost of administering grant awards. (As for

the latter, the September 11th Fund covered administrative costs by getting

special grants from a cadre of foundations).

January/February 2003

Vol. 44, No. 1

BACK TO INDEX

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But the American Red Cross was soundly criticized for dipping into its $1

billion Liberty Fund in order to replenish its contingency fund, to cover its

substantial administrative expenses and to set aside money for long

–

term

needs. This dipping led to claims of broken promises, mismanagement, the

resignation of agency executives, and ultimately, the loss of public trust and

reputation.

A recent poll by

The Chronicle of Philanthropy

found that 42

percent of

Americans have less confidence in charities now than they did before the

September 11 attacks because of the way charities have handled

donations made for relief and recovery. Nearly 3 in 10 said that they would

be less likely to contribute to all types of charities because of how funds

were disbursed.

Is the culprit in public erosion of trust in the nonprofit sector the failure to

meet the standard of “100 percent goes to charity” or is it the very claim

itself?

While people are pleased to think that all of the money they give will go

directly to fill urgent needs, should the public remain blissfully ignorant

about what it takes to actually deliver services? Or should donors expect

nonprofit organizations to operate without administrative or fundraising

expenses?

The Purity Question

On the surface, “100 percent goes to charity” seems innocent and even a

positive strategy to direct assistance where it is most needed. Donors want

their contributions to do the most good for the people they want to help:

food going to the hungry, for example. Funders also want a direct

connection to the people being served. By directing dollars to service

delivery, they may feel a little closer to the target.

Behind this, however, is both ignorance and mistrust. Ignorance of how

programs actually operate. Mistrust that nonprofit organizations do not

function efficiently or honestly.

There is a deep

–

rooted suspicion among many donors about the legitimacy

of administrative expenses and other indirect costs. Those expenditures

are difficult to explain, let alone cost out or evaluate, in relation to the public

benefit achieved. Media attention to high salaries for some nonprofit

executives (albeit primarily at the country’s largest nonprofits) have made

many donors even more uncomfortable with funding administrative

expenses, especially expenses for what they might consider excessive

compensation and unnecessary amenities. As a result, the notion of “100

percent goes to charity” is attractive to many funders.

Proponents of this approach believe they are securing a “chastity belt of

accountability”: restricting what they view as unnecessary or wasteful

activities and promoting organizations’ adherence to their charitable

purpose. These donors hope that by limiting the resources applied to

administration and fundraising, charities will be forced to be frugal and

efficient in operations. They will have to be more focused on their missions

and the services they provide. When funding is tight, foundations argue that

providing restricted funding for programs will guarantee that the most

important things get done. But is the restriction of “100 percent goes to

charity” a good prophylactic for accountability to charitable purpose? After

all, history has shown how misguided and abusive the chastity belt was.

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The strategy of “100 percent goes to charity” misses the bigger picture. It is

a significant deterrent to effective and high

–

quality service delivery. It

undermines the capacity of individual nonprofit organizations to address

their constituencies today and in the long term. Let’s explore the dark side

of the “100 percent to charity” approach, identify the significant benefits of

underwriting the full costs of service delivery and outline an active role for

foundations in increasing public understanding of nonprofit organizations.

Direct vs. Indirect

Behind every good program is a

good organization. In other

words, programs do not exist in

isolation, but depend upon the

organizational infrastructures in

which they are housed. They

are products of governance,

management and fundraising.

An organization’s ability to

provide services relies on a

host of indirect expenditures.

Let’s examine this.

What are direct costs?

The

intrinsic costs of running a

program are often referred to as

direct costs

program staff

salaries, program supplies and equipment.

What are indirect costs?

The term

indirect costs

encompasses a broad

range of expenses that enable the organization to offer the program, but

are not specifically used to conduct program activities. Indirect expenses

are typically the fixed costs of running the organization that benefit all of its

programs: rent/mortgage, utilities, janitorial services, insurance, accounting,

administrative and clerical staff and fundraising activities. (See “

What’s

Indirect

” for a list of common indirect costs). Indirect costs are also called

overhead, administrative

management expenses

, or

general operating

costs

(see “

What Exactly Do You Mean By That?

” for a glossary of

terms).

Indirect Costs Are Essential.

Here it will help to use an example to

explore the relationship between indirect costs and the ability of an

organization to provide a program.

A foundation wants to support afterschool programs that enable at

–

risk

children to be successful students. It is considering making a grant to the

boys and girls club in an impoverished neighborhood for a new computer

lab serving local children. The grant could be restricted to cover the cost of

acquiring computers and the first year’s salary of two tutors. However, it

would be impossible for the club to offer the lab on an ongoing basis

without such things as the club’s building (occupancy costs), insurance (of

diverse types), overall staffing (receptionist, personnel administration,

benefits program), financial accountability (bookkeeping, annual audit),

institutional technology (cabling, networking, internet access), and quality

control (licenses, evaluation, administrative oversight and coordination with

the club’s other programs). The lab is also the result of institutional

commitments involving: priority setting as part of strategic planning, board

investment, fundraising and visibility (community outreach and cooperative

relations with local schools).

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These indirect costs are essential to the organization’s capacity to provide

the afterschool program, but they also support all of its community

programming. They cannot be attributed to a single program. However, a

portion of those expenses should be allocated to each of its programs to

clearly identify the true costs of running the program.

Given these factors, the foundation decided to incorporate a 20 percent

supplement in its program grant in order to contribute to the indirect

expenses involved in running the computer lab (see “

What’s a Good

Indirect Cost Percentage

” for appropriate amounts). The foundation

board concluded that this type of support would increase the chances that

the club could effectively operate the lab for years.

Organizations House Programs.

Solid infrastructure and financial

solvency are crucial to an organization’s ability to deliver services. If an

agency is having problems with aspects of its overall administrative

functions, the quantity and quality of services will suffer. If an organization

is unable to meet its own needs

pay the rent, retain an executive director,

keep accounting up

–

date or provide a safe and clean working

environment

it cannot be a vital resource to meet the current needs of at

–

risk children. Nor can it continue to contribute to the well

–

being of the

community.

Furthermore, funding indirect, as well as direct, costs contributes to cost

effectiveness, reinforces professionalism, provides capitalization for new

programs and increases long

–

term sustainability of nonprofit organizations.

The Double Standard

Who pays for indirect costs? Unfortunately, few foundations, corporations

or individuals embrace this type of support, even as a portion of their

contributions. This reluctance reveals a double standard that plagues the

nonprofit sector.

In the for

–

profit sector, executives would be fired for mismanagement or

would soon run their businesses into the ground if they did not incorporate

indirect costs such as occupancy expenses, research and development,

upgrading technology, administrative and financial management and

advertising into the cost of goods and services. Yet foundations and

corporate giving programs frequently review grant proposal budgets and

slice out items

such as a percentage of the executive director’s salary,

fundraising expenses or agency overhead

when they make their final

award. Arguments for removal include: “They can get that elsewhere,”

“These are not really part of the program,” or “These are not essential

expenses.” Here we see two standards: one for effective business

practices and another for the way nonprofit organizations are supposed to

operate.

Despite much criticism that nonprofits are not operating like businesses,

funders undermine nonprofit organizations capacity to do so whenever they

omit indirect costs from their grants.

Another double standard is reflected in the calculations for foundations’

minimum payout rate. A host of indirect costs contribute to a foundation’s 5

percent distribution calculation, including administrative costs, trustee

compensation, travel, professional development, clerical staff and other

overhead expenses. These are included because they are seen to

contribute to a funder’s ability to fulfill its grantmaking mission and goals.

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Yet, many foundations restrict grant funding to direct expenses for

charitable organizations. Nonprofit organizations, often having the least

amount of unrestricted income, are held to a different standard than what

foundations apply to themselves. However, for nonprofit organizations to

sustain programming, they require revenue streams that match the realistic

expenses of the organization, just as foundations and for

–

profit businesses

do.

Too frequently, funders also maintain two standards for what we say is

important and what we will pay for. Foundations increasingly require high

levels of financial accountability, evidence of strategic planning and

evaluation documentation, all of which help funders make informed

decisions and enable nonprofit organizations to maintain quality and

efficiency.

However, those activities are costly. Planning involves significant

investments of staff and board time as well as funding. Evaluation often

involves retaining outside professionals and involvement of staff resources.

While independent audits are more important than ever, they can cost

anywhere from $10,000 to $50,000.

Unfortunately, nonprofit organizations have learned donor preferences too

well. Many nonprofit managers likewise do not account for all the costs that

contribute indirectly to their ability to offer programs. Program staff

sometimes view fundraising professionals or administrators as a separate

realm and do not see the interconnectedness of their work. Even those

nonprofit managers who know the relationship of core operating expenses

and direct program costs often do not assert the need for this type of

support to funders. Nonprofits are not in a strong negotiating posture when

requesting a grant to keep their programs in operation.

Back to the question of who pays for the broad range of administrative and

indirect costs. Nonprofit organizations commonly fund those expenses by

charging fees to the clients they are serving or by holding fundraising

events that yield unrestricted income. More often than not, they starve the

administrative side of the organization or have to forego investing in their

infrastructures altogether. This can have a detrimental impact on quality,

efficiency, modernization, staff retention and sustainability.

Embracing the Essential

The foundation and corporate giving community has a remarkable

opportunity to shape public understanding of how nonprofit organizations

operate. By abandoning the “100 percent to charity” mantra and embracing

indirect costs as essential to service delivery, we can promote the effective

operation of nonprofit organizations and encourage public trust in nonprofit

management.

Perhaps we need a new term that communicates the relevancy and

importance of these activities.

Indirect costs

overhead

, and

administrative

expenses

do not convey the correlation of the expenditures to the quality

and quantity of programming. Instead, insert a budget line item for

infrastructure expenses

core agency support

organizational investment

to solidify the link.

Indeed, foundations and corporations can play a primary role in educating

themselves, the public and nonprofit organizations about the central

importance of indirect costs. They could lead by example simply by

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suggesting to potential grant recipients that they include a percentage for

indirect costs in their proposal budgets, and then, actually providing funding

for this line item. Nonprofit managers, for their part, need to quantify the

actual costs of running programs and include indirect expenses in project

budgets. They need to articulate what those costs are and champion how

interrelated they are to service delivery. Through this leadership role,

foundations and nonprofit organizations can begin dissolving the climate of

suspicion surrounding administrative and fundraising costs and raise a

standard of nonprofit sector sustainability.

Glossary

What Exactly Do You Mean by That?

When the Support Center for Nonprofit Management

(

www.supportctr.org

) in San Francisco conducted its important

study

Indirect Costs: Practices and Perspectives

nearly a decade ago

(1994), it found “a striking lack of consensus . . . on terminology in topics

involving indirect costs, including a definition of indirect costs, whether

various line items should be classified as indirect costs, and on appropriate

percentages for indirect costs.” Furthermore, according to the same study,

“the two most prominent national accounting standards differ in

recommended treatment of indirect costs.”

While we acknowledge there may not be universal agreement on definition

of all of the terms, we offer here a review of the best recent efforts to define

the terms:

Direct Costs.

Those costs that are clearly and easily attributable to a

specific program. (see Alliance for Nonprofit Management, “How can we

allocate indirect costs to programs?”

www.allianceonline.org/faqs.html

)

Indirect Costs.

Those costs that are not easily identified with a specific

program, yet are necessary to the operation of the program. The costs are

shared among programs and in some cases, among functions (program,

management and general fundraising). (see Alliance for Nonprofit

Management, “How can we allocate indirect costs to programs?”

www.allianceonline.org/faqs.html

)

Overhead/Administrative Costs.

(used interchangeably) All expenses,

such as rent or insurance, that are not directly related to a particular part of

the work or product. (see

Webster’s Collegiate Dictionary

)

Management and General Expenses.

These expenses are for the

general functioning of the organization but not related to fundraising or

programs.

Such expenses include the salaries of the CEO and the CEO’s staff for

activities not related to fundraising or programs. Other costs include those

associated with meetings of the board of directors or similar governing

groups; legal services; accounting; liability insurance; office management;

auditing; personnel; preparation, publication and distribution of an annual

report; and investment expenses not related to programs or rental income.

(see GuideStar, “Glossary,”

www.guidestar.org

) Consider also the slightly

different definition of Management and General Costs found in another

source, defined as “organizations’ costs related to the essential activities

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identifiable with no one of their primary functions but indispensable to the

conduct of all of them and to an organization’s corporate existence.” (see

National Health Council, National Assembly of National Voluntary Health

and Social Welfare Organizations, and United Way of America, Standards

of Accounting and Financial Reporting for Voluntary Health and Welfare

Organizations.

www.nhcouncil.org/pubs/pub_list.htm

)

General/Operating Support.

This is a grant made to further the general

purpose or work of an organization, rather than for a specific purpose or

project; also called an Unrestricted Grant. (see The Foundation Center,