12/23/2010 04:05 pm ET | Updated May 25, 2011

On Charities: Is Microscopic Overhead a True Measure of Effectiveness?

In the late 1980s, the U.S. government's foreign assistance program Administrator, USAID's M. Alan Woods, accepted some advice from a friend: let your contractors use product donations in support of their projects and let them count the dollar value of those donations as part of required "matching funds" for certain types of USAID grants. Woods thought that was a great idea as one way to attract private corporate support for the then-unpopular U.S. foreign assistance program.

With the same passion they have for raising cash, America's brand name international relief groups as well as a legion of entrepreneurial televangelists and scam artists began accumulating what they claimed were billions in corporate largess. The companies were happy to give away unsold products even if the tax advantages were not much better than simply writing these off as unsold inventory. American companies regularly produced huge surpluses and tapping into them for the benefit of the American people and the wider world was a good thing.

What no one realized at that time was the parallel use these "in-kinds" had as a means of diluting administrative and fundraising overheads by factoring in vastly inflated product values which even the IRS has historically been unable to properly regulate. "Fair Market Value" is both the IRS' and the in-kind supply groups' mantra but these valuations are squishy at best and depend on where in the chain of production and sale the donations originate (e.g., manufacturers' donations may claim far less in costs and value than a donation from a retailer who bought products from a wholesaler or directly from the manufacturer). In general, these claims are rarely, if ever, audited by the IRS.

An ever-growing number of nonprofits have approached the $1 billion mark in annual non-cash donations. The competition among them has led to near-exponential growth on their non-cash side and greatly confused the donating public when they attempt to read through an annual report or IRS I-990 report... or, tellingly, a charity watchdog site.

What does it mean when a charity with few employees and modest cash income reports one billion dollars in "revenue"? Are they hugely effective? Is a .001 percent overhead reason to give to them? What more ought a donor know about the charity beyond its numbers?

Some aid groups have taken over $200 million in valuations from Mebendazole, an anti-parasitic medicine given away by the very few companies which make it for lack of anyone willing or able to pay up to $16 per pill. In the hands of an in-kind supply group, however, it's pure gold -- a hugely useful medication if they can widely distribute it in Africa while it has remaining shelf life and, as an "evaporator" of overheads. A $20 million dollar revenue and expense budget with $5 million in fund raising and administrative costs becomes a $220 million budget and a 25 percent overhead becomes a 2.2 percent overhead.

Charity watchdog sites and even the Chronicle of Philanthropy, perhaps the most important periodical of the nonprofit community, are thrown off by this. Top ratings for efficiency and capacity (based at present mostly on the IRS I-990 form with some reforms being developed by the sites) are awarded and the in-kind solicitations method then spreads to ever-more groups... many with no history or capacity to handle or target supply donations. Some lack even a warehouse to store them and donations to them are near-virtual in nature. More than a few corporate donors have been snookered by brand name relief groups just now entering the supply game, primarily as a means of lowering their overheads and then dumping off these supplies on other nonprofits for their own use. The IRS generally allows up to two nonprofits to count as income and expense the same supply donation -- as in a chain of distribution -- but any more than that is labeled "ping-ponging" a donation, something a number of evangelical groups have been caught doing as have some very dubious "disease" charities with stratospheric fundraising costs.

Foundations are probably the first to question this near-out-of-control process in their grant-making evaluations. While not discounting a robust and well-targeted supply program, they are ever-more skeptical of the numbers they receive. The public, however, loves low overheads and rarely reads through an annual report or I-990. Procurement directors at nonprofits are pressured to generate high value supply donations regardless of their use in the group's programs. Some are even purchasing donated supplies from other nonprofits on the promise of a $20 to $1 valuation for the cost to them of obtaining the supplies. This re-selling of donated products for what are euphemistically called "service or processing fees" can amount to millions of dollars per year for the initial recipient of a corporate supply donation. Corporate donors are apparently unaware or unconcerned that this practice is widespread.

What is reasonable? Does a 2 percent overhead mean "terrific" and "well-run" or does it indicate that a group is run too cheaply to do staff training, monitoring of projects or even have adequate facilities?

Increasingly, 10 and even 15 percent for operating costs appear reasonable if reported by groups whose programs are transparent and effectively meet a pressing need. USAID funds many groups whose negotiated contract overheads are well above even 20 percent.

Someone there is seeing through the "microscopic overhead" PR hype and not penalizing groups for having legitimate and necessary core operating expenses... just as America's most successful businesses and entrepreneurs do.