Nonprofits must report how much they spend on operating expenses but this isn't always a fair indicator of performance.
By Stephen Fishman, J.D. · USC Gould School of Law
If you run a nonprofit, how much are you supposed to spend on operating expenses? You have two choices: you can spend as much as you need, or as much as looks good. Most nonprofits choose the latter, but that doesn't mean it's a wise move.
Nonprofits that file IRS Form 990 must allocate their annual expenses into three categories:
- program expenses—expenses directly related to carrying out your nonprofit's mission, and that result in goods or services being provided--for example, expenses to teach a class, put on a performance, provide health care, or deliver food or clothing to the indigent
- administrative expenses—expenses for your nonprofit's overall operations and management—for example, costs of board of directors' meetings, general legal services, accounting, insurance, office management, auditing, human resources, and other centralized services, and
- fundraising expenses—including costs for publicizing and conducting fundraising campaigns, maintaining donor mailing lists, conducting special fundraising events, and any other activities that involve soliciting contributions.
Together, administrative expenses and fundraising expenses make up a nonprofit's "overhead," or "operating expenses."
The IRS does not require that nonprofits spend any particular portion of their income on each category. It just wants nonprofits to report how they spend their money.
There is no single formula or ratio all nonprofits use to determine how much of their total budget should go to operating expenses. But, the commonly accepted rule most of them follow is the less spent on overhead, the better a nonprofit looks to donors.
Charity rating organizations grade nonprofits partly on how much they spend on these expense categories. For example, CharityWatch.com says that it's reasonable for most charities to spend up to 40% of their budget on operating expenses—in other words, at least 60% should go to programs, and 40% should go to everything else. However, charities that spend less than 40% get higher grades from CharityWatch, with those spending 25% or less on operating expenses receiving the highest "A" grades. Charity Navigator, which employs a sophisticated rating system, gives bonus points to nonprofits with lower operating expenses. Most nonprofits who spend more than 30% of their budget on overhead get no bonus points. The Better Business Bureau says that no more than 35% of a nonprofit's budget should be spent on operating expenses.
Unfortunately, the desire to keep overhead costs as low as possible has had pernicious effects on many nonprofits. One study found that the lack of overhead investment has left many with insufficient office space, nonfunctioning computers, and staff members who lack the training they need to do their jobs properly. In one case, a nonprofit had furniture so old and beaten down that the movers refused to move it.
In addition, many nonprofits engage in accounting tricks or outright dishonesty to keep their reported overhead costs as low as possible—sometimes ridiculously low. This is aided by the fact that the IRS does not require nonprofits to allocate expenses in any particular way. A study of over 220,000 nonprofits found that more than a third reported no fundraising costs at all, while one in eight reported no management or general expenses. The researchers concluded that 75% to 85% of these nonprofits were improperly allocating their expenses.
Things have gotten so bad that the heads of the three leading nonprofit rating organizations--GuideStar, Charity Navigator and BBB Wise Giving Alliance—created a website called The Overhead Myth. The website includes an open letter from the heads of these organizations denouncing the "overhead ratio" as a valid indicator of nonprofit performance.
August 2013
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