NFP performance is often measured on overhead ratio. And funders are not prepared to support indirect costs. Both approaches are drastically flawed a new report reveals.

“I think that funders expect not-for-profits to be exceptionally lean,” says Ilana Atlas, non-executive director of the ANZ Banking Group, Origin Energy and the Scentre Group, chairman of nonprofit, Jawun, and board director of the Paul Ramsay Foundation.

“You know ‘the smell of an oily rag’ is obviously a commonplace phrase that we all use and, mea culpa, I have used it many times in saying how wonderfully efficient not-for-profits are.”

Ilana was speaking at the recent online launch of Philanthropy Australia’s latest report: ‘Paying what it takes – Funding indirect costs to create long-term impact’. And what she says gets to the heart of what has been so wrong, for so long, in the thinking about nonprofit funding: that responding to complex issues and delivering vital services with minimal funds, and even less long-term financial surety, is to be worn as a badge of honour.

“Similarly, there’s an expectation from not-for-profits that funders won’t pay properly,” she continues. “From my personal experience, you really feel you can’t disclose a profit at the end of the year, because if you [do], you aren’t saying [you are] worthy of funding.

“So all of this means you don’t create a buffer – you don’t create a reserve, which of course means that your organisation is not sustainable.”

What Ilana is talking about will not be new news to many of you. If you have been involved in applying for grants and seeking philanthropic support, you will no doubt be familiar with the bruising rebuff of “We don’t fund operational costs”, “We only fund new projects”, “We don’t fund business as usual”, or “We only fund innovation”.

‘New’ and ‘innovative’ leads the way when it comes to sparking interest. But what about the nuts and bolts that make new and innovative projects possible in the first place? What about your core service that builds the trust and knowledge upon which you can pilot new programs? The people and causes you must continue to serve every day while testing innovation? Your back of house staff in finance, HR, IT and marketing roles who keep the wheels turning while you trial different ideas? And all the gritty, unsexy, unavoidable cost-incurring necessities that play such an integral role in your ability to make a difference to the world – transport, postage, printing, utilities, insurances, rent, volunteer management… the list goes on.

It can be demoralising and frustrating and bending to fit the mould only perpetuates the problem. But there is hope! For the first time in Australia, Philanthropy Australia (PA), in partnership with the Centre for Social Impact (CSI) and Social Ventures Australia (SVA), have published a report that takes a close look at the current state of (insufficient) funding for NFP ‘indirect’ costs, the impact this current landscape has on nonprofit wellbeing, and what we can do about it.

We will start by looking at the current health of the NFP sector in Australia.

Hanging by a thread

Charities, nonprofits and the wider social purpose sector are critical to Australia’s society and economy. Charities alone have annual revenue of $155 billion and employ over 1.3 million people in Australia, around the same number of people as retail trade (10.0%). Charities are the second largest employing industry after health care and social assistance. They also engage over three million volunteers and provide over $12.7 billion of unpaid labour.

This means they account for over 8% of Australia’s GDP and one in ten of Australia’s employees. They provide services that people, communities and government rely on. They also deliver vital services – from disability services to early learning – on behalf of taxpayers, the Commonwealth and state governments.

Unfortunately, this contribution and effort does not reap nonprofits the rewards of stability and sustainability.

Over the past year, PA, CSI and SVA have explored financial vulnerability of charities in their Partners in Recovery research series, which includes an analysis of the financial health of over 16,000 charities using Australian Charities and Not-for-Profits Commission (ACNC) data. The reports have shown that:

  • Many charities operate with thin or no margin and did so even before COVID-19 – in the financial year that preceded the pandemic, 25% of charities operated in deficit and an additional 35% operated with a profit margin of less than 5%.
  • Many charities operate with limited reserves – modelling found that a 20% decline in revenue due to COVID-19 would result in 17% of charities being at high-risk of closing their doors in six months.
  • Most charities reported that 2020’s events had put strain on their financial operations – a PA survey of more than 200 charities in late 2020 found that 77% reported that recent events had put strain on their financial operations and 52% were worried they would not be able to provide their services in the current economic climate.

It is not that these organisations have been mismanaged, but that they have been pushed into ‘running lean’ by various forces for many years. This leanness has risks and it means nonprofits have a reduced ability to adjust to economic shocks.

US research has shown that one of the key drivers of this vulnerability is insufficient funding of NFP ‘indirect costs’ such as HR, IT and finance. This feeds into the ‘non-profit starvation cycle’, in which funders having inaccurate expectations of how much overhead is needed to run a nonprofit, resulting in these NFPs underrepresenting their costs in order to appease funders. This leads to a sector starved of the necessary core funding required to create resilient nonprofits delivering long-term impact on complex social issues.

The research has led to a long-running campaign in the US to change perceptions of overhead by philanthropists and the government, which has successfully influenced several key funders to move towards a full-cost approach to funding.

“The ‘non-profit starvation cycle’, [is] funders having inaccurate expectations of how much overhead is needed to run a nonprofit, resulting in these organisations underrepresenting their costs.”

Turning to the issue on our own shores, the report shows we have a long way to go in Australia. Not least because the way in which funders assess nonprofit impact and worthiness is drastically flawed.

First – how to define ‘indirect costs’

Funding of indirect costs, or lack thereof, is a problem for nonprofits in Australia. But what exactly does ‘indirect cost’ mean?

The report defines indirect costs as those incurred by an organisation that cannot be directly and easily attributed to a specific project. This means if the project did not exist, the organisation would likely still need to incur this cost. Indirect costs include IT, finance, human resources, learning and development, measurement, and evaluation.

Challenges with measuring nonprofit impact

When it comes to securing funding, nonprofits are not just required to justify their own work on its own merits but are also expected to do so in relation to what other organisations are doing. And yet, nonprofit impact, by its very nature, is difficult to measure. For example, it can be hard for an NFP engaged in advocacy work to isolate their own contribution to a policy change. Similarly, tracking and isolating long-term impact can be difficult in dynamic environments where an organisation might be providing a range of support services.

Cross-sector comparison of outcomes and outputs is incredibly difficult – for example, the output of a health service might be measured in the number of patients that visit a health clinic, whereas an advocacy organisation might contribute to a shift in policy that makes it easier to access free health services. One is much easier to measure than the other. Yet, comparison is a central feature of decisions about funding, with cost-benefit comparisons being an important component in deciding between which organisations to fund. Because comparisons like this can be very difficult to make, it means other characteristics and attributes can be used instead of comparing outcomes – with funders often turning to indirect costs.

Every organisation has an overhead ratio. This is regardless of the sector or industry they work in. Overhead ratio is a readily available measure, one that people feel that they understand, despite not being a good measure of nonprofit effectiveness.

What is needed is realistic measurement expectations and an acknowledgment that, for some forms of work, measuring contribution is a significant challenge. This challenge should not be used, however, as a justification to use cost ratio as the foundation of comparison.

“[Overhead ratios] are a readily available measure, one that people feel that they understand, despite not being a good measure of nonprofit effectiveness.”

And then there is another issue. Under resourced nonprofits often do not have the means to perform accurate measurement – a cruel irony where the lack of funding inhibits the capacity of an organisation to spend time tracking their true levels of indirect costs.

The report’s key findings

Indirect costs do not indicate the efficiency or effectiveness of a nonprofit

Research cited in the report shows that NFPs that spend less on indirect costs are not necessarily more efficient or effective than those who do not. In fact, there is clear evidence that allocating insufficient funds to indirect costs can potentially reduce overall effectiveness. There is also some evidence that higher-impact nonprofits may actually invest more in indirect costs.

“NFPs that spend less on indirect costs are not necessarily more efficient or effective than those who do not.”

And yet, a significant proportion of Australian funders, both philanthropic and government, only fund a specific percentage of indirect costs or still use indirect costs to differentiate NFPs. For many years, they have used the proportion of funds an organisation spends on indirect costs as a way of assessing nonprofit efficiency or effectiveness. Indirect costs are examined closely by funders, donors, and the media to determine which organisation to support, usually with the lens of lower indirect costs being preferred.

The ACNC agrees that indirect costs are a poor measure of nonprofit effectiveness and is publicly opposed to using indirect costs as a method to compare NFPs:

“All charities spend money on administration – without it, they wouldn’t be able to operate and pursue their charitable purposes. It can be misleading to consider administration costs as separate from a charity’s cause, because this fails to recognise parts of a charity’s operations that enable it to deliver services.”

Australian nonprofits reluctantly underinvest in indirect costs

Financial analysis of nine NFPs revealed that their average indirect costs were 33% (of revenue), similar to the 29% identified in US research. Every organisation included in the research reported they had difficulty funding the true costs of what it takes to deliver impact. Most believed they were underinvesting in indirect costs, and several acknowledged that they underreported their direct costs to funders in order to win funding. There was general agreement that more than 20% on indirect costs in a grant application started looking ‘high’, and organisations would generally self-censor to stay at or under that level.

“Several [nonprofits] acknowledged that they underreported their direct costs to funders in order to win funding.”

Let us also reflect on nonprofit versus corporate – a comparison the community and media seem reluctant to make when it comes to what ‘deserves’ to be paid for. The average nonprofit indirect cost expenditure is significantly lower than that of businesses. For-profit organisations can spend as much on indirect costs as is deemed appropriate for their organisation, a fact that rarely comes under scrutiny. Companies under $1 million in revenue, for example, spend on average 48% on indirect costs, not including research and development.

The graph below shows how much several case study organisations (included in the Mercer Human Resource Effectiveness Monitor 2015 report, adjusted for inflation to 2020 dollars) spent on key capabilities per employee, such as training and IT. Based on Mercer benchmarks, Australian businesses are spending on average 1.8 – 3.6 times more per employee than case study nonprofits across a range of important costs.

A huge variance between nonprofits is another reason why indirect costs are a poor gauge of performance. PA’s research identified a range that spanned 26% to 47% of revenue allocated to indirect costs. For example, an organisation in the disability sector is likely to have additional costs for quality controls and regulatory compliance to ensure safe, high-quality care compared to an organisation in the arts sector.

Size is a consideration as well. One large nonprofit noted that the way funders approach indirect cost funding can actually serve to erode the gains from economies of scale. While some costs are centralised, large NFPs will often use local suppliers and project teams for work that could be done centrally, purely to ensure that those costs are considered direct costs rather than indirect costs.

Next, increased demand for outcomes measurement, which is typically an indirect cost for nonprofits, and trends towards greater regulation means pressure on indirect costs is rising.

It’s important to note that these issues are not limited to philanthropy. The graph below shows that no funding source of any kind is coming even close to covering both direct and indirect costs.

“Funders want good financial systems and governance but aren’t willing to pay for it.”

Business development, services establishment, research, service design, policy and advocacy, governance and risk management, media and communications and decommissioning or exit costs are all expenses commonly excluded by funders.

As a small nonprofit interviewed in the research said: “Funders want good financial systems and governance but aren’t willing to pay for it.”

Placing caps on indirect costs leads to lower impact, increased risk and financial vulnerability

Spending insufficient resources on overheads or indirect costs can impact overall nonprofit effectiveness, equating to lower quality program outcomes. The most recent results from the PricewaterhouseCoopers (PwC) not-for-profit CEO survey highlights this issue, noting that: “Not-for-profits are under intense pressure to keep administrative costs low even though healthy operating costs allow organisations to execute their mission more effectively.”

Many nonprofits in PA’s research share that cost restraints resulted in challenging working conditions for staff, that include being overworked, underpaid and having low job security due to short-term funding arrangements. Unsurprisingly, these organisations also report high rates of attrition.

Insufficient spending on indirect costs can also lead to increased risk to clients, as well as increased risk of non-compliance with regulatory requirements and, ironically, funders’ own specifications.

Nonprofits use a variety of strategies to cope with the persistent underfunding of their core costs, many of which are either actively harmful or simply inefficient. Other than cutting back indirect costs, the most common is searching for ‘untied’ philanthropic funding to backfill the gap left by insufficient program funding – a process that takes up precious time and significantly drains resources.

One NFP mentioned there was a tendency to not hire administrative staff as needed, instead pushing the burden onto program staff to reduce indirect costs. They said: “You’re incentivised to burden front-line staff with admin because donors will pay for that.”

One less common but often effective technique is being upfront with funders about the true indirect costs of the organisation. However, where a relationship of trust does not currently exist between nonprofits and funders, the power dynamics and entrenched beliefs about indirect costs result in many NFPs being hesitant to take this approach.

Power dynamics with funders strongly influence nonprofit behaviour

In short, those with control over funding decisions drive the conversation. And it is most often the case that funders determine which issues they want to fund. What follows are nonprofits shaping their strategy based upon what they perceive funder expectations to be. At times this can lead organisations to feel like they are being made to work to a mission that is not their own.

“Those with control over funding decisions drive the conversation.”

Beyond determining the starting point of conversations, funders also set the limits of the conversation, through their expectations around what levels of overhead should look like, and what levels of overhead are tolerable.

Nonprofits exist in a highly competitive funding environment

The combination of widespread financial vulnerability and a highly competitive funding environment is a critical driver of the nonprofit starvation cycle. This limits the capacity of NFPs to push back against unrealistic funder expectations around levels of indirect costs.

“It’s about getting the money, and not rocking the boat – because you actually get less and less opportunities to even have a conversation about funding,” said one nonprofit in the research. Another shared, “You can’t criticise them, they’ll pull your funding.”

What we are witnessing is an environment where nonprofits are often fighting for survival and unable to challenge norms that are negatively impacting the sector.

There is a trickle-down effect to media and community

Media reporting around indirect costs is almost universally unfavourable in Australia. This reporting is likely to pressure charities to behave in line with public expectations, as it is directly linked to their reputation. Similarly, having a negative reputation related to overhead spending can be harmful and lead to a loss of public donations.

“Nonprofits are grappling with an imperfect model of funding assessment controlled by funders and perpetuated by the media, donors, the public and, often, themselves.”

These messages have been internalised by NFP staff as well. One nonprofit said that there was a sense of guilt shared by staff – a mindset that it was more important to spend money on ‘the mission’ than on investing in the organisation.

So here we, nonprofits are grappling with an imperfect model of funding assessment controlled by funders and perpetuated by the media, donors, the public and, often, themselves. But progress in the US has shown that it is possible to change the narrative and PA, CSI and SVA have some clear thoughts and suggestions about how we get started in Australia.

The solutions

Part of the report’s evidence collection was to gather insights into what nonprofits and funders are already doing to address the issues outlined above and what they thought might work in the future. What was notable in the solutions that were raised is that some of the strategies only required subtle changes, not a radical reconstruction of the funding landscape.

One interviewee (a funder) explained that because they used closed tenders it gave them a stronger level of confidence in conversations around overheads. They put a high degree of effort into their screening process to ensure that the organisations they worked with were of a high standard. By finding organisations based upon a belief that they undertook good work, it meant that the cost structure of the organisation was less important in their decisions about whether to fund them.

Interviewees also raised the importance of trying to reduce reporting pressure on nonprofits and stressed that it was about trusting organisations to undertake the work to the best of their ability, with one funder explaining: “Once we fund them, the funds are untagged. And we do want reporting for transparency, learning, relationship building, but we don’t get into the details of the budget – we trust non-profits to get on with their business.”

“Interviewees also raised the importance of trying to reduce reporting pressure on nonprofits.”

Others noted that multi-year funding was an important mechanism to reduce financial vulnerability for NFPs.

The report’s calls to action:

  1. The report encourages sector leaders to support a range of activities and initiatives that educate nonprofits, funders, government, the media and the general public that:
  • Funders, both philanthropic and government, should focus on impact when assessing NFPs
  • A credible, independent set of definitions and data on indirect costs should be created
  • Low indirect costs do not mean that a nonprofit is being impactful, and high indirect costs do not imply that it is not impactful
  • Effective NFPs incur indirect costs that need to be funded to enable them to achieve their impact. Funders can increase their impact by offering full-cost funding
  • Understanding impact requires investment in measurement systems
  1. Both funders and nonprofits should be encouraged to have an open, productive dialogue around the true costs of any proposed programs or initiatives.
  2. There is a need to create a credible, independent source of data on the typical quantum or range of indirect costs. This will support a safer environment for charities to speak with funders about actual costs – rather than underreport. However, given indirect costs can vary significantly between organisations (for legitimate reasons related to business models and choices as to where to invest) be cautious about using them in benchmarking.
  3. Sector education initiatives can create a common language and foster understanding of what constitutes indirect costs.
  4. Funders and their charity partners will be well served by building trusting relationships which support open and transparent conversations. Due to power dynamics, funders will likely need to be the first mover in many conversations.
  5. Increased collaboration across the philanthropic sector to share learnings on how to fund indirect costs will help accelerate change across the sector – and potentially provide evidence to then influence government.

Where to from here

Nonprofits and funders must create a common language and understanding around indirect costs, the report emphasies. This understanding will facilitate transparency of what the average indirect cost scale is, which the report hypothesises to be greater than 30% for the average NFP. Whilst a nonprofit explaining overheads and their purpose can influence funder choices and decrease overhead aversion, the power imbalance means the onus must be on funders to take the first steps to change.

The ‘pay-what-it-takes’ approach to philanthropy was first proposed in an article from the US-based Bridgespan Group, which articulated the dire situation of NFP funding in the US and how a new way of thinking about organisational funding was needed. It proposes a different grantmaking approach: “One that provides enough money for nonprofits to pay for all their operations, not just programs and services.” What a wonderful outcome that would be.

Philanthropy Australia CEO Jack Heath says best practice in Australia has started to change, as foundations including the Myer Foundation, the CAGES Foundation, and Origin Energy Foundation implement some form of full-cost or untied funding. The release of PA’s report coincided with the recent Paul Ramsay Foundation announcement that they will adopt an interim 30% for indirect costs across grants, with flexibility to shift lower or higher where rationale is shown.

PA will be hosting workshops throughout 2022 with the aim of building a coalition of leaders in philanthropy and the charity sector to determine the best path forward. This is just the first step. The work will continue in three stages. The first stage is to understand how organisations can support and resource taking the pay-what-it-takes approach. The second is around developing the tools and the budget templates that will facilitate this, and the third is learning how to change the conversations that we are having, both internally within NFPs and between, and with, funders.

In 2023, PA will launch a community of practice, where members will be able to support the pay-what-it-takes approach and share the learning experience and tools.

Once change is affected in the philanthropic sector, the plan is to move onto the government funding sphere.

“It’s about bringing your humility to the conversation. It means whether you’re a not-for-profit or a funder, it’s about bringing your own vulnerabilities to create a space where that can happen,” says Jack.

Let’s hope that, with a generous helping of vulnerability, honesty, and reality, we can reach a place where nonprofits are no longer required to minimise and hide the very infrastructure that enables them to open their doors each day.

Methodology

The evidence we collected in the report included:

  • A literature review of Australian and international research – 72 sources from the existing academic and grey literature on ‘the non-profit starvation cycle’, with an emphasis on sources that covered the Australian context.
  • Nine financial analysis case studies of small and large nonprofits
  • 15 interviews with small and large nonprofit leaders
  • 10 interviews with philanthropic funders
  • 15 interviews with other sector participants.

You can access the report and sign up to receive more information as this research progress, here.

You can watch the repot launch here.

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