One of the big changes in FASB’s latest accounting standard update for not-for-profits, ASU 2016-14 (Topic 958): Presentation of Financial Statements of Not-For-Profit Entities, may not be much of an issue for many of your clients because they may already be doing what’s now mandatory.

Starting with years ending after Dec. 15, 2017, all not-for-profits are required to report expenses by functional category, as well as by natural description. Most organizations already divvy up their expenses into the three categories of program services, general and administrative, and fundraising for their Form 990s, although previously only voluntary health and welfare organizations were required to do so.

This functional expense allocation can be reported on the face of the financials, in a separate schedule or in the notes. Not-for-profit organizations must also include a description of the methodology used to allocate their expenses between their program and support functions.

Is overhead a useful measure of effectiveness?

FASB wanted to bring consistency to reporting because “reporting expenses by nature and function is useful in associating expenses with service efforts and accomplishments of NFPs.” But, is the allocation of expenses between functional categories really a useful measure of whether an organization is making effective use of its resources?

Spending too much on support activities can be a red flag, and the media is full of stories of not-for-profit organizations squandering donations on luxury items and oversized salaries for executives. Such reports frequently result in a decrease in donor support for those organizations, which may put that organization out of business.

But, spending too little on administration can be just as deadly. The key is a balance between efficiency and effectiveness. As management guru Peter Drucker said, “Efficiency is doing the thing right; effectiveness is doing the right things.”

A challenge for not-for-profit organizations is the disconnect between what the public perceives as being efficient, which, for many donors, means spending only 15 or 20 percent of total revenues on overhead, and what an organization actually needs to spend to be effective in accomplishing their mission.

This disconnect results in the “overhead myth:” the belief that the most efficient organizations are also the most effective, and which organizations, such as the BBB Wise Giving Alliance, Guidestar and Charity Navigator, are trying to end. As research by Grey Matter indicates, most donors have no idea how much their favorite charities spend on overhead expenses, and may misjudge the actual amount by as much as half.

The starvation cycle

According to research from the Bridgespan Group, restricting overhead forces organizations to make short-term decisions that can threaten the long-term ability of organizations to fulfill their missions. This short-term focus leads to a vicious cycle, which the researchers dub the “starvation cycle:”

• Step 1: Organization funders have an unrealistic view of the costs to operate the organization.
• Step 2: The organization feels pressure to adhere to the funders’ unrealistic expectations.
• Step 3: The organization tries to adhere to funders’ expectations by spending too little and underreporting their actual overhead on their 990 and in fundraising materials.
• Step 4: Underspending and underreporting perpetuates the funders’ expectations.

We’ve all seen first-hand how the starvation cycle impacts the finance function at our not-for-profit clients. Under pressure to keep salaries low, the organization might hire someone as a part-time bookkeeper and office manager. Because the salary is low, turnover in that position may be high, which means that the quality of the work is uneven. Poor oversight and weak internal controls can even lead to embezzlement and fraud.

A better approach

Instead of limiting overhead to an arbitrary low limit, a few funders and not-for-profits have been advocating a new approach, which they dub “pay what it takes.” This approach acknowledges that different organizations have wildly differing cost structures. For example, not-for-profit research laboratories spend a median of 63 percent on overhead, while direct service organizations may need only 25 percent to cover their overhead.

This approach also recognizes that organizations that invest in the resources they need are more likely to be successful in the long run. As this letter from the three organizations trying to end the “overhead myth” suggests, we can help our not-for-profit clients be more effective by helping them determine the true costs of achieving their missions.