Nonprofit Efficiency Measures
Written by: Pete Kennedy, CPA, Director of Audit Services
For as long as I’ve been involved with nonprofit organizations, expense-based financial ratios (Program / G&A /Fundraising as a percentage of total expenditures) have been used as an efficiency measurement. I’m sure you’re familiar with them – and the many derivatives that appear online in the form of ratings or top / bottom ten lists. Knowing what we do about nonprofits and their finances, the widespread use of such statistics has always stuck in my craw. We stopped paying attention to blindly calculated top and bottom ten lists which are often based on these ratios a long time ago. Some organizations work extremely hard and efficiently but perform poorly in those limited calculations. Presenting a set of financial statements and / or form 990 with ratios that appear poor to a nonprofit executive director who puts their heart and soul into the mission is a disconcerting experience. In spite of our understanding of the limited utility of such ratios, many people and organizations take as gospel the notion that an organization that spends less than 70% on direct program expenses is inefficient. That executive director with the poor-looking ratios knows, with the stiff competition for charitable contributions and grants, those ratios place him/her at a heavy disadvantage.
There are many examples of the fallacy behind the use of such ratios, but one issue that plays out often at our clients relates to the use of volunteer labor. In terms of true efficiency, it is impossible to get more efficient than free, yet organizations that use volunteers for program purposes will appear (in a blindly computed ratio) to be less efficient than another organization which uses paid labor for the same purpose.
Recently, a very interesting study was published (“Toward a Valid Approach to Nonprofit Efficiency Measurement” by Jason Coupet and Jessica L. Haynie – published August 2018 by Wiley Online Library). The study begins with a very basic and logical concept – efficiency is defined as the ratio of inputs to outputs. The classic ratios of program / management and general / fundraising to total expenses have always thought of the dollars raised as the input and the manner in which those dollars are spent as the outputs. What if these measurements have been wrong all along and actual mission performance is the output? With that being the case, how can any efficiency measurement that ignores true output (performance) be valid?
The study argues quite convincingly that it can’t. In setting out to prove that, the authors used a population of 792 Habitat for Humanity organizations for which Form 990 data was available. Not only did their study show a lack of positive correlation between the standard performance metric and output efficiency (measured for Habitat for Humanity by the numbers of homes built new, rehabilitated, or repaired against total dollars spent) it showed a slight negative correlation. So, Habitat for Humanity affiliates in the population that had higher G&A as a percentage of total expenses actually produced slightly more output per total dollars spent. Anecdotally, several of the affiliates with the worst expense ratios actually had output efficiency measures that were among the highest in the population.
My highly unscientific explanation for the negative correlation and anecdotes goes something like this: with so much at stake, nonprofits are constantly under pressure to show lower G&A expense ratios – to the point where you shouldn’t find it hard to believe some might try to take highly aggressive approaches to reclassify G&A expenditures into program (I could tell you some stories….). For an organization to stick to a completely impartial and honest view of their expense categories in the face of that pressure takes a significant amount of managerial fortitude. Managerial integrity and fortitude at nonprofits tends to show up in other areas too – like morale and employee productivity. So a factor which causes an organization to report higher G&A expenses vs. its peers could also cause it to be more productive and efficient.
We’ve been skeptical about Program / G&A / Fundraising expense ratios and their use as an efficiency measure for some time and it’s nice to see that skepticism empirically validated. Hopefully, this study will gain some traction and cause those making gift decisions to reconsider their conception of expense ratios as providing decision-useful information. We’ve said it before but it bears repeating; if anyone chooses to make a gifting decision using blindly computed expense ratios, well, it’s their money. But if you want to be sure that your gift will make a difference, there is no substitute for getting involved, seeing what they do, attending events and volunteering.