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Administrative Costs and Overhead

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Don't yawn and click on another link yet. Administrative costs and overhead sound really boring, but they're critically important for nonprofit organizations and also for donors, most of whom don't appreciate their importance. This post will set out the basic concepts, and the next will apply them to Dan Pallotta's provocative book, Uncharitable.

The ideal of every organization and those who support it is not to minimize, but to optimize all costs, including administrative costs. That is, the costs incurred by an organization are appropriate to the extent, and only to the extent, that they contribute net value to the organization's mission.

To use an example from the business sector, assume that a widget manufacturer's only mission is to make a profit for its owners. Then, an additional administrative expense of 1¢ is justified if it is likely to produce an additional 2¢ of profit.

The underlying idea is not different for nonprofits. Their missions are to achieve particular social, environmental, educational, religious, health, etc. goals. And an incremental expense is justified to the extent it has the potential to increase the organization's net social value. Administrative costs include items such as utilities, back-office functions, and strategic planning. Many of these are treated as "overhead" or "indirect costs" because they are not directly connected with any particular program the organization operates but rather support all of its programs.

Whether in the business or nonprofit sector, the concept of optimizing administrative costs has this implication: You can only assess the reasonableness of an organization's costs in terms of their effect on its achievement of its mission. A high-performing organization may have high administrative costs that contribute to its great impact, while another organization may have very low administrative costs and have little if any impact on the problems it seeks to address.

The practices of other nonprofit organizations can provide a useful benchmark for one's own practices. All things considered, organizations of the same sort and size--for example, food banks, symphony orchestras or large staffed foundations--tend to have administrative costs in the same general range. Having to justify significant variances imposes a healthy discipline on an organization' management and trustees.

Unfortunately, many funders are reluctant, or even unwilling, to pay their fair share of administrative costs, especially when these costs are characterized as "overhead." This tendency is exacerbated by many funders' unwillingness to provide organizations with unrestricted general operating support.

Some services that evaluate nonprofits actually contribute to donors' misunderstanding of the role of administrative costs by rating organizations based on their administrative costs as if these costs had meaning apart from their contribution to its social impact. In fact, some organizations with very low administrative costs may be under-investing in financial accounting systems, human resource development or other administrative functions that that are critical to effective governance, achieving their organizational missions, and public accountability.