Demystifying Your Nonprofit’s Overhead Ratio: How To Calculate It
Overhead costs are among the list of expenses for nonprofits. They are often seen as bad — in fact, many nonprofit executives reward their employees for spending little — but this could not be more wrong.
In reality, maintaining a low overhead does not help your organization achieve its goals. Overhead is essential to reach your mission, so you should not use it carelessly and simplistically as a metric for success. To help you understand why, we created this guide.
- What Is Overhead?
- How To Calculate Your Overhead Ratio
- Why Your Overhead Ratio Is Not a Measure of Success
- Final Thoughts
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What Is Overhead?
Overhead includes a combination of general expenses that an organization incurs to run smoothly. Without the right staff, marketing, and more, charities are unlikely to gain the traction they need to raise funding and make change.
Some typical examples of overhead costs include:
Operational costs, such as rent, salaries, and insurance
Functional costs, such as advertising and IT services
Administrative costs, such as legal and accounting services
The IRS’ implications of overhead costs depend on the form you use to report your expenses. For example, IRS Form 990 separates management and general costs from fundraising costs. The complexity this results in can make defining this category overwhelming. Therefore, you need to use your judgment and possibly hire a professional to get through this process.
How To Calculate Your Overhead Ratio
Once you decide what you are putting under the overhead umbrella, calculating your overhead ratio is easy; divide your total overhead by your total income. Your nonprofit’s revenue is essentially composed of incoming donations, grants, membership dues, and any other funding you receive.
Anthony is doing some mental math to calculate his nonprofit's overhead ratio.
For example, if your monthly overhead cost is $10,000, and your monthly income is $40,000, you would divide 40,000 by 10,000. The total in this case is 0.25, which translates to 25%.
So, what is generally considered a "good" overhead rate? Take a look at these barometers:
The Better Business Bureau uses 35% or less as a marker.
Government contracts range from 0% to 25%.
Charity Watch gives poor ratings to foundations with ratios that are 40% or higher.
Why Your Overhead Ratio Is Not a Measure of Success
When it comes to the health of your nonprofit, you have to ask yourself: what are you getting vs. what are you giving? Running a nonprofit is not free. Let’s discuss why this is relevant to the debate on nonprofit overhead costs.
You Get What You Give
Many people think nonprofits should run on little-to-no money. But, have you ever considered the overhead for large for-profit companies? Amazon, Google, and Apple have all had to take big risks to get where they are today. These companies did not nickel and dime administrative costs or program expenses. If your nonprofit organization implemented innovative and sometimes costly strategies like them, how much of an impact could you make?
For starters, advertising costs money. You cannot spread the word about your cause without spending money. The saying, "You have to spend money to make money" is true! Fundraising events, Google ads, and other marketing attempts attract more supporters. More supporters fund your nonprofit’s growth.
Overhead that is too low is a concern. Your overhead should be a picture of the steps your nonprofit is taking to make change. A low overhead can be a sign of a relaxed nonprofit that needs a recharge.
A Brighter (and More Realistic) Future
Instead of obsessing about maintaining a low overhead rate, consider:
Peter is feeling at peace after demystifying his nonprofit's overhead ratio!
The big picture is not that your overhead costs are low, but that you are spending funds wisely. If spending more on this particular fundraising event is going to lead to a quality experience that turns more potential donors into actual donors, then go for it! When executives or donors come to you after the fact to ask why you spent what you spent, you can point to a successful event that brought in more money (in donations) than it cost to host.
Pro Tip: If you need a little help convincing others in your organization to change their mindset on overhead, give them an example. For instance, imagine your organization hosts a carwash and spends only 5% on overhead, but the total net for charity is $100. Now imagine you host a dinner event that spends 40% on overhead, but the total net for charity is $1 million. Does the overhead percent matter in this comparison? Certainly not!
It takes money to run any business or organization, even a nonprofit one. Other nonprofits are beginning to experience the benefits that can result from changing how they measure success. Instead of solely focusing on maintaining a low overhead by keeping program expenses low, they have pivoted their goal to spending their funding in ways that they can justify. You can do this too!
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💡How much can a nonprofit legally spend on overhead?
The IRS has no legal requirements about how nonprofits spend their funding, but they do have to report their spending. Find out more.
🔑 What is a good overhead expense ratio?
There is no one-size-fits-all answer for this, though experts from the Better Business Bureau, CharityWatch, and other organizations use 40% or lower as a benchmark. Find out more.
📝 What is overhead in a nonprofit budget?
Overhead is the full cost of running a nonprofit, which includes office rent, office equipment, staff salaries, and more. Find out more.