Nonprofit Financial Management Topics: Is the Overhead Ratio Model Obsolete?

Nonprofit financial management courses and books often lean on the old standby of the overhead ratio model to judge the efficiency of the nonprofit.

But what if we told you that new research indicates that the overhead ratio model may be outdated? It may actually be a weak measurement of nonprofit efficiency.

Here’s why.

Are We Basing Nonprofit Work on Outdated Notions?

Much of the way our modern business culture functions is based on fairly outdated notions stemming from the industrial revolution. For example, the factory model of mass production may be outdated in an era in which computers can offer mass customization, and the internet provides nearly limitless choices for consumers.

This notion transfers to the world of nonprofit financial management, too. In the business world, the old idea of managerial efficiency stems from the definition of “turning inputs into outputs.”  To measure efficiency, many nonprofit analysts use the overhead ratio. The overhead ratio compares the ratio of overhead expenditures to total expenditures.

New research published in the journal Nonprofit Management and Leadership points out that this is actually a poor judge of efficiency for nonprofits.

Researchers from the University of North Carolina’s Public Administration program examined the literature of efficiency in the nonprofit world and realized that this is a flawed model. Unlike a factory, in which efficiency may indeed be judged by the ratio of inputs to outputs, nonprofits must measure their spending differently.

The overhead approach largely ignores the mission of nonprofits, how they utilize their expenditures, as well as inputs other than typically quantifiable inputs. Nonprofits can also increase their overhead ratio without decreasing efficiency. For example, buying grant management software may significantly improve efficiency if it allows the nonprofit to produce more (obtain more grants) even if the overhead expense increases from the software purchase.

The old overhead model just doesn’t cut it anymore for the modern nonprofit.

Don’t Get Rid of the Overhead Model Yet, But Evaluate It Differently

It’s still too early to get rid of the overhead model entirely. Even the IRS cites the overhead model in many of its documents for nonprofits.

However, instead of relying solely on overhead ratios as a judge of efficiency, consider using a different model. Financial ratios, when taken into account with program completion and success ratios, may be a better metric by which nonprofits should be judged.

Let’s take as an example a nonprofit whose purpose is to provide medical services for the homeless. Their inputs are donations, but how do you measure their outputs? By the number of projects they conduct or complete?

You can’t put a price on human lives or health. The number of people screened for diabetes may be one metric of “output” but the greater the “outputs,” the lower the efficiency, according to the old scale. Meanwhile, donors judge the nonprofit not by how tightly they cling to their money but by how many people they help.

A much better method by which to judge such a nonprofit is how well they used their funds to accomplish their mission. If their funds went towards clinics, medicine, and care for the homeless, for example, then their expenses will be high, but their efficiency may also be high if they use their personnel and resources wisely. The purchase of a new mobile health clinic may be a significant expense, but if it enables them to reach 20 times more people, it is indeed a sign of improved efficiency.

Nonprofit Financial Management Always Changing

It just goes to show that the world of nonprofit financial management is always changing. What we once took for granted as an established fact – the method of measuring nonprofit efficiency – may require rethinking. Nothing, it seems, is ever written in stone, especially when it comes to nonprofit financial management.

Beck & Company

Beck & Company is an independent certified accounting firm specializing in nonprofit organizations. Since 1987, we have helped many nonprofits in the Washington D.C. area and along the Eastern seaboard with their accounting and financial management needs. We provide audit, tax, accounting, and consulting service that addresses all aspects of a small to mid-sized nonprofit organization’s business. Contact us or call 703-834-0776 x8001.