The Overhead Ratio is Not a Measure of Efficiency

By Shalina Omar

In a recent study coming out of NC State, researchers Jason Coupet and Jessica Berrett challenge the status quo of using financial ratios for measuring the efficiency of nonprofits. The researchers argue that relying on measures like the overhead ratio is an inappropriate evaluation of efficiency because it does not consider outputs. Instead, they suggest alternative models, pushing for a more instrumental approach that can take into account the actual services that nonprofits provide.

How Nonprofits Evaluate Efficiency

How efficiently a nonprofit is able to turn resources into goods and services for their communities is an important concern for all stakeholders. Knowing whether the organization is running efficiently can help advise management on spending strategy or qualify the organization for funds like foundation donations and government grants. Currently, the go-to measure of efficiency in nonprofit management literature is the overhead ratio. This is the financial ratio of overhead expenditures (like salaries, office management, human resources, etc) to total expenditures. The reasoning behind this practice is that money that is spent on overhead costs could be spent on programming instead, so overhead costs are wasted money. Using this model, third party organizations, such as Charity Navigator, rank nonprofits that spend the least on overhead costs as the most efficient.

The Flaws in the Overhead Ratio

Dr. Jason Coupet

However, Coupet and Berrett point out that this line of thinking is fundamentally flawed and can even incentivize inefficient behavior. The key problem is that efficiency is concerned with the ratio of inputs (resources the nonprofit has on hand) to outputs (the benefit produced for the community). Financial measures like the overhead ratio only take into account monetary input and do not address output at all. Imagine, for example, two food kitchens serving meals that serve the same number of meals and spend the same on overhead costs, but one spends more on programming. With the overhead ratio model, the organization that spends more on programming will be ranked as more efficient than the organization that produces the same output for lower cost.

Despite its drawbacks, both scholars and practitioners in the nonprofit sector rely heavily on the overhead ratio. The pressure to keep overhead costs low can prompt organizational managers to go against smart management strategies, instead starving themselves of necessary overhead resources and unnecessarily increasing program spending in order to minimize the overhead ratio.

Two Alternatives to the Overhead Ratio

Efficiency is about what nonprofits are able to produce (the outputs) from what resources they have (the inputs) and Coupet and Berrett argue that efficiency cannot be measured without considering the outputs. In this study, the researchers compared the overhead ratio with two other measures of efficiency, Data Envelopment Analysis (DEA) and Stochastic Frontier Analysis (SFA) in evaluating nearly 800 affiliates of Habitat for Humanity, whose mission is to supply underprivileged people with decent and affordable housing.

Unlike financial ratios, DEA and SFA are able to account for different types of input as well as output. In this research, the inputs included both overhead and program expenses and the outputs were the number of houses that Habitat for Humanity provided, whether they were new, rehabilitated, repaired, or recycled. As opposed to relying only on the financial inputs, DEA automatically assigns weights to the inputs and outputs that maximize efficiency and calculates an efficiency score. SFA also accommodates both the inputs and outputs but is able to consider randomness and statistical noise by taking into account inefficiency, or the extent to which an organization’s actual output falls short of its maximum possible output.

Comparing Models

Jessica Berrett

Coupet and Berrett compared these efficiency measures by ranking each Habitat for Humanity affiliate according to these three models. The researchers found that, despite assessing efficiency from two very different approaches, DEA and SFA were significantly and highly correlated with each other, meaning that both models assigned similar efficiency rankings to the same affiliates. On the other hand, financial ratios like the overhead ratio or the administrative ratio (which is the same as the overhead ratio but does not include fundraising costs as part of the overhead) were either not significantly correlated or even negatively correlated with the output-inclusive measures.

When ranked by the overhead ratio, the top-ranking affiliate had a very low ratio of less than one percent, but it only produced two new houses. In contrast, the top-ranking affiliate according to SFA provided 382 houses. It ranked 43 for DEA, but because the overhead was 32% it ranked 676 according to the overhead ratio. The top-ranking affiliate according to DEA produced 26 houses. It ranked number two by SFA but came in at 713 for overhead ratio because overhead was 36%.

The researchers contend that these results show how ill-equipped the overhead ratio is for evaluating the efficiency of nonprofit organizations because it ignores key inputs and is incapable of accounting for outputs. In this study the overhead ratio ranked an organization that produced only two houses as the most efficient and ranked other affiliates as “inefficient” even though they were deemed highly efficient by both DEA and SFA.

Why Nonprofits Need to Abandon the Overhead Ratio Model

Coupet and Berrett warn that not only is the overhead ratio is a poor measure of efficiency, but the industry’s reliance on it as a gauge for organizational performance discourages nonprofits from managing strategically by incentivizing them to focus only on the overhead ratio. As an alternative, Coupet and Berrett are pushing for a more instrumental approach, such as DEA or SFA, which are a better barometer of what a nonprofit actually does with what it has.

Nonprofits themselves can use more accurate ratings like DEA or SFA as a benchmarking tool and make strategic decisions based on a more inclusive measure of efficiency. Having an accurate gauge of nonprofit performance is also important for third party organizations that rate nonprofits either directly or as a qualification for resources.

Given the importance and influence of efficiency rankings within the nonprofit sector, researchers Coupet and Berrett urge nonprofit managers as well as donors and scholars to move away from using financial ratios to measure organizational efficiency. Taking outputs into account is vital for strategic management and accurate evaluation of efficiency.

For additional information, please visit NC State News.

Shalina Omar is pursuing a Master’s of Arts Degree in English with a concentration in Sociolinguistics at NC State University. She is a former intern to the Philanthropy Journal and is currently a teaching assistant in the NCSU linguistics department.

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