The undertow of overhead
Indirect costs for nonprofit arts organizations aren't (usually) a sign of waste. They're part of the puzzle that makes the mission work.
The world begins at a kitchen table. No matter what, we must eat to live.
The gifts of earth are brought and prepared, set on the table. So it has been since creation, and it will go on.Joy Harjo, from “Perhaps the World Ends Here”
“When a measure becomes a target, it ceases to be a good measure.” Such is the simplified and paraphrased lesson of Goodhart’s Law, which warns that any metric used to control or shape a system becomes useless for thoughtfully understanding that system. Once people know the target, Goodhart suggested, they will bend toward it regardless of the consequence.
One tragic example in the nonprofit arts is the “overhead rate,” a simple but confounding metric that should be useful but has instead become a dangerous distortion.
In business accounting, “overhead” represents a bucket of costs that can’t be readily assigned to a product or service. That bucket can include rent, general wages, utilities, office equipment, software, supplies, maintenance, insurance, and other necessary expenses. In short, overhead is the kitchen table, not the meal.
The “overhead rate” is the proportion (percentage) of indirect expenses to all expenses. So, if annual indirect costs for a nonprofit are $25,000 and total annual expenses (direct and indirect) are $100,000, the overhead rate is 25 percent. In other words, 25 cents of every dollar spent by the organization goes to overhead.
From the donor or foundation perspective, that metric seems like a clear and clean way to compare nonprofits. If two organizations approach the same mission, the one with lower overhead rate must be the more effective and efficient. More money is going directly to programs and services, after all, so that must be better. And they should get the funding.
But that common-sense assessment is actually catastrophic at scale, just as Goodhart’s Law would predict. Donors and funders signal a preference for low overhead rate in their distribution of money. Nonprofits compete for that contributed income by cutting (or distorting) their overhead costs. That leads to anemic investment in infrastructure, sparse or spare essential services, and less clarity around costs for everyone. And the metric loses its value for nuanced understanding and strategic action. So the circle continues.
Ann Goggins Gregory and Don Howard labeled this the “nonprofit starvation cycle,” and blamed it for entire domains of nonprofit organizations growing weaker over time (Gregory and Howard 2009).
To make the problem even worse, every nonprofit has a different relationship between direct and indirect costs – depending on what they do, how they do it, where they do it, and what ecology supports them. A recent study of arts nonprofits suggested an “optimal” rate between 35 and 43 percent (Altamimi and Liu 2022). But there’s no magical and correct answer across all organizations.
What’s the path out of the starvation cycle? Goodhart’s Law suggests we have to stop using overhead rate as a policy measure for contributed income. Once released from that trance, we might have a useful and candid discussion between nonprofits and their funders.
In the meantime, funders and nonprofits can only swim against the current toward open and honest negotiations around what overhead means, what it indicates (or doesn’t), and how it entangles with the outcomes they both want in the world. My recent discussion with Jill Robinson in TRGArts’ “Leading the Way” podcast (Spotify, Apple Podcasts) offers a few conversation starters on that topic.
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From the ArtsManaged Field Guide
Function of the Week: Accounting
Accounting involves recording, summarizing, analyzing, and reporting financial states and actions.
Framework of the Week: Core Mission Support
This framework offers a reimagined representation of non-program expenses in a nonprofit organization, showing them not to be wasteful investments but rather essential core elements of the work.
PHOTO by Zoltan Tasi on Unsplash
SOURCES
Altamimi, Hala, and Qiaozhen Liu. “The Nonprofit Starvation Cycle: Does Overhead Spending Really Impact Program Outcomes?” Nonprofit and Voluntary Sector Quarterly 51, no. 6 (December 1, 2022): 1324–48.
“Goodhart’s Law.” In Wikipedia, November 6, 2023.
Gregory, Ann, and Don Howard. “The Nonprofit Starvation Cycle.” Stanford Social Innovation Review 7, no. 4 (2009): 49–53.