Overhead cost ratios are a poor metric for assessing the effectiveness of charities, and donors' focus on such costs often constrains organizational effectiveness, a study published in IZA World of Labor finds.
The study, "Are Overhead Costs a Good Guide for Charitable Giving?" by Texas A&M University associate professor of economics Jonathan Meer, found that overhead ratios are an unreliable metric of a charity's effectiveness, in that they depend on average, rather than marginal, expenses. The study also found that many programs require administrative support in order to function effectively, and that using donations to boost fundraising results and awareness can be an effective use of funds. At the same time, the study found that donors were strongly swayed by administrative costs and were less likely to give — and gave smaller amounts — to programs or charities with higher overhead cost ratios, even when those costs had no bearing on the quality or effectiveness of a program. In one field experiment, people who were told that another donor had made a large donation to cover the overhead costs of a program gave twice as much as those who were told a donor had made a large donation or that the donation would be used to match additional gifts, and three times as much as those who were simply asked to give.
The focus on overhead cost ratios negatively affects charities' operations, the study argues, because it often leads organizations to underinvest in talented employees and necessary infrastructure. In addition, the inability to pay competitive wages due to concerns over administrative costs leaves charities at a disadvantage in the labor market, limits the pool of talent available to them, and results in a general lack of support for key functions and staff.
The study highlights a number of alternatives to overhead cost ratios as a metric for effectiveness, including the twenty standards promulgated by the Better Business Bureau Wise Giving Alliance and Charity Navigator, which evaluates the financial health and transparency of charities using multiple criteria and is working to add measures of effectiveness to its ratings.
"Donors clearly respond to overhead cost ratios to an excessive degree, with research showing that the aversion to high overhead costs can shift donor behavior to a great extent," Meer writes. "However, this focus hurts nonprofit organizations' effectiveness by limiting their ability to compete in the labor market and by altering their administrative structure in a counterproductive way."