A new grantmaking approach is needed—one that provides enough money for nonprofits to pay for all their operations, not just programs and services. The first step toward achieving that is for grantmakers to realize that different types of nonprofits have different cost structures.

Pay-What-It-Takes Philanthropy,” the Summer 2016 article on the Stanford Social Innovation Review website, inspired these reactions to the article.

Paul Brest

Faculty Codirector of the Stanford Center on Philanthropy and Civil Society and Lecturer at the Stanford Graduate School of Business

Indirect Costs, Freeloading, and Myopia

If a foundation refuses to fund indirect costs, the burden should be on it to justify that decision.

If we had a set of standards for the indirect cost rates for various types of charitable organizations along the lines suggested in the “Pay-What-It-Takes Philanthropy” article, foundations would have two clear options. Either pay total costs, or acknowledge that they are only willing to pay a lesser percentage and demand that the organizations compromise their missions or raise matching funds to cover the shortfall.

Let’s assume that a foundation knows a grantee’s actual indirect cost rate and acknowledges its reasonableness. Under these circumstances, what justifications might the foundation have for paying less than full indirect costs under a project grant? (The issue of indirect costs arises only when a foundation makes project grants, as distinguished from unrestricted, general operating support grants. But project grants are perfectly appropriate when a grantee’s activities are not well aligned with a foundation’s mission.)

Let’s consider a foundation that makes a project grant to a small research organization to assess the potential for an asthma-prevention program, and subsequently makes a project grant to a youth-serving organization to implement the program. Let’s assume that the foundation is impact-oriented and also feels constrained by principles of fairness. How should it decide whether to pay the grantees’ indirect costs?

If impact were the foundation’s sole consideration, its decision about indirect costs would turn on whether it is making a one-time grant of relatively short duration or needs the organization around for the long haul.

If it is a one-shot deal, as the research grant might be, the foundation could take advantage of whatever slack the organization has—and virtually every organization has some. It could underpay—that is, pay only direct costs—and let the organization make up the difference if and how it can. Presumably, if the organization cannot maintain itself and goes out of business, that is a matter of indifference to this impact-only foundation, which believes that it will not need the organization in the future. It’s worth noting, however, that the organization which, for this foundation, is a one-off grantee, may be a core grantee for another foundation, and vice-versa. So even in this case, the foundation should consider its decision in the context of the entire ecosystem.

If the foundation knows a grantee’s actual indirect cost rate and acknowledges its reasonableness, then a decision to underpay is arbitrary: The foundation might just as rationally say that it will only pay 75 percent of total costs, or any percentage it chooses. In effect, it is demanding that the organization match some proportion of the grant from existing resources or new gifts from others.

It the foundation decides to make a grant to implement the program, it will want the implementing organization to endure at least long enough to carry out the program—probably a period of several years—and, after that, for an indeterminate time to continue the program if it is successful. In this case, underpaying indirect costs will exacerbate what the authors and others have aptly described as the “nonprofit starvation cycle.” Deprived of full payment, the organization may, for example, put off upgrading the computer system to keep track of its disadvantaged clients or forgo sending staff to a training program to improve their work. It’s not just the organization that suffers, of course, but the very beneficiaries that the foundation seeks to serve. So the foundation may decide that it must pay full costs to assure the organization’s vitality as long as the foundation cares about these clients.

Turning to the matter of fairness, does a foundation treat the grantee unfairly when it makes a grant without paying its full costs? To be sure, the organization does not need to accept the grant. In reality, however, many organizations, feeling unable to reject the funds, accept the grant and scramble to fill the gap by forgoing strategic investments in infrastructure or training—again, at the expense of their beneficiaries—or through “creative” accounting or from other sources—for example, small individual contributors or foundations that provide general operating support.

Is it fair to ask other donors to pay the indirect costs that the foundation won’t? Perhaps they would recognize that this is essentially a demand for matching funds and be grateful that the foundation is paying most of the costs for a new program. But for better or worse, many donors are averse to paying indirect costs, strongly preferring that their funds go directly to programs that provide services to the beneficiaries—the same sort of myopia that motivates our foundation to pay less than full fare.

So the burden of justification falls on foundations. They should be asked to justify their refusal to pay the actual costs of the activities they want grantees to perform, and I haven’t seen many foundations try to do that.

Paul Brest is former dean and professor emeritus (active) at Stanford Law School, a lecturer at the Stanford Graduate School of Business, a faculty codirector of the Stanford Center on Philanthropy and Civil Society, and codirector of the Stanford Law and Policy Lab. He was president of the William and Flora Hewlett Foundation from 2000 to 2012.

Carolyn Miles

President & CEO of Save the Children

Outcomes, Not Benchmarks, Are the Real Goal

The article “Pay-What-It-Takes Philanthropy” advanced the social sector conversation about overhead, or indirect costs, by introducing the notion of segmenting the sector to benchmark costs among similar organizations. While that’s the right way to go as the next step in the conversation, it’s not the ultimate goal. The real win is when we focus on measuring outcomes for nonprofits—a goal both straightforward and sometimes extremely difficult to achieve.

Doing a better job of measuring the impact of NGOs’ programs and services requires an investment in research and continuous improvement. That’s an indirect cost that donors have to pay for, and today most don’t. The link between NGOs understanding their true indirect costs and donors stepping up to fund measurement is important and will drive our sector to the next level.

Similarly, the segmentation of the social sector begun by the article is an important step forward. It shows that within a group of similar organizations, such as research organizations, cost structures are more alike than not, and that cost structures differ from one group of organizations to another. The question I have about benchmarking is: What’s the ultimate purpose? Benchmarks are important for informing internal conversation about real costs. After all, we’ll never solve the so-called nonprofit starvation cycle unless nonprofits know what it costs to do their work well and can have meaningful conversations with their donors.

But benchmarks should not be the sole way to rate organizations. That would mean that we are still evaluating organizations on their costs. Having come (albeit long ago!) from the for-profit sector, the idea of measuring success based on a cost structure alone has always confounded me. Ultimately, we should be evaluating on our outcomes.

At Save the Children, we have conducted our own cost analysis across all 30 member organizations for the past several years, gradually getting better at defining our costs and understanding what drives them. We have looked at what we all spend on general administration, fund raising, operational support, and program costs, as well as breakouts within those costs. Having this data informs our internal conversation about expenditures. It shows where we have overinvested or underinvested and leads to questions about why that is the case.

We can now start to use the cost information to get better—and to put more of our donors’ money into driving outcomes. For Save the Children, that means children’s lives saved, children getting to and staying in school and learning, and children protected from harm. Those outcomes are not always easy to measure, but there are ways to do so. That is what I want our work to be evaluated on.

Some would argue that we are stuck in an overhead cost conversation rut because we don’t know how to measure outcomes. There are probably no universal outcome measurements, but when asked, most organizations can show outcomes data from projects. We might not have a standard way to measure outcomes across different organizations, but that doesn’t mean we should give up on talking about them. Within Save the Children, we can now globally track the numbers of children reached directly and indirectly, in emergencies and development contexts, and by sector response. We can measure access to education, and in 12 countries we can predict gains in reading skills in our Literacy Boost program. We can measure the delivery of life-saving interventions like anti-malarial treatment, treatment for pneumonia, and treatment of diarrhea—the things that kill children under five years of age. We can measure the number of health workers we train and tie these to countries’ overall maternal and child survival rates. None of these measures are perfect, but they are surely better than measuring the percentage we spend on general and administrative services alone.

“Pay-What-It-Takes Philanthropy” has stoked a growing conversation about funding true costs. The sooner we understand those costs and ensure they are covered, the quicker we can move on to tackling the ultimate goal of measuring outcomes.

Carolyn Miles (@carolynsave) is president and CEO of Save the Children, an organization that gives children in the United States and around the world a healthy start, the opportunity to learn, and protection from harm. The global Save the Children movement currently serves more than 143 million children in the United States and in more than 120 countries.

Fred Ali & Antony Bugg-Levine

President and CEO of the Weingart Foundation | CEO of the Nonprofit Finance Fund

Grantmaking Should Be Grounded in Real Costs

Building trust and understanding between funders and grantees is a vital part of pay-what-it-takes philanthropy.

This article, “Pay-What-It-Takes Philanthropy,” is a heartening sign of the growing recognition that supporting nonprofit organizations with limited, restricted funding does not work. So what can we all do to make sure this recognition leads to systemic change that sets up nonprofit organizations for success and honors funders with the results their generosity deserves?

The answer is simple in theory. As Ford Foundation President Darren Walker notes in the article, we must “encourage more honest dialogue about the actual operating costs of nonprofit organizations.” But how do we practically make that work in the absence of a mutual commitment to build trust between funders and grantees?

We are trapped in a mindset that stigmatizes spending beyond direct program work. This mindset keeps many nonprofit leaders from recognizing and pursuing the investments needed to drive long-term impacts. And too many funders underestimate the unequal power dynamic inherent in their interactions with grantees. Analysis alone cannot overcome this cultural challenge. We must commit to a process that is mutually empowering.

We agree with the premise of the article that effective grantmaking should be grounded in understanding the real costs of operating individual nonprofit organizations, rather than a single-rate, one-size-fits-all approach. Based on our experience having run, funded, advised, and/or lent to thousands of nonprofit organizations, successful approaches begin with an open and comprehensive understanding of the full costs each organization requires to achieve results. This understanding recognizes that:

1. Full costs differ over time. A nonprofit poised to buy a building will have very different indirect cost needs than the same organization three years later. And the cost structure even of the same program can differ from, say, year one to year five. Calculations of full cost that focus on what an organization has needed to operate in the past often do little to help us understand what it needs to adapt to the future.
2. Full costs differ by context. We have seen situations where local nonprofits operating under the same national umbrella organization have very different cost structures because each branch is responding to its local context (not because some are necessarily more “efficient” than others).
3. Full costs are about more than covering indirect costs or overhead. Healthy nonprofits are able to save and borrow to respond to changing community needs and to safeguard services in times of crisis. Even an organization with its indirect costs covered will not necessarily develop this capacity.

Fortunately, we are beginning to understand this. In California, the Nonprofit Finance Fund, the California Community Foundation, the Weingart Foundation, and 12 regional nonprofit organizations are piloting a program to enable nonprofit and foundation leaders to explore full costs together. This project is helping nonprofit leaders and foundation program officers build a shared understanding of full cost that goes beyond indirect rates to include the full set of costs a resilient organization needs to cover. This work is bringing nonprofits and funders together for honest discussion about what it takes to fund social progress. We are unpacking the power dynamic that hinders candid conversation about true organizational needs.

Early results are encouraging. As one nonprofit participant noted: “Because there were funder and nonprofit staff together around the table, I thought it was one of the most beneficial and ‘real’ convenings I had been to. I thought the perspectives and openness were so refreshing and challenging.” 97 percent of participants reported increased comfort advocating for full costs.

Although this particular process may not work for everyone, it may be worthwhile to consider testing it among funders and grantees nationally, adding to the research agenda called for in the article. Most important, all funders and nonprofit leaders can help foster more honest dialogue in these ways:

• Funders: Reorient funding discussions and requests around the results you want grantees to achieve, rather than how you want them to spend money. Signal that you understand the constraints your grantees face. And provide general operating support. If you do not trust your grantees to know best how to use that support, how do you expect them to trust you? (And why are you funding them in the first place?)
• Nonprofits: You must articulate clearly the impact you generate with the resources you raise, which takes time and effort you likely do not have. And we realize that it can be reckless to fully disclose organizational needs to some funders. So start by asking the hard questions internally—that will at least make you better informed about your own full costs. Then identify which of your funders would be willing to discuss the implications of these insights. There are more of them than you think.

As noted in the article, it’s time for new approaches to grantmaking. These approaches should be rooted in a practical and comprehensive understanding of what it takes to build an effective and sustainable nonprofit organization. This will require committing to honest interaction between individual funders and nonprofit organizations to overcome the mutual distrust that often overwhelms the full cost conversation.

Fred Ali is president and CEO of the Weingart Foundation, a Los Angeles-based foundation committed to improving the capacity and effectiveness of nonprofit organizations serving people and communities in need.

Antony Bugg-Levine (@ABLImpact) is CEO of the Nonprofit Finance Fund, a consultant and lender that helps funders and nonprofits across the United States collaborate to achieve maximum impact for their investments and efforts.

Hilary Pennington

Vice President for Education, Creativity, and Free Expression at the Ford Foundation

Focus on Building Strong Organizations

Even for a foundation committed to funding impact rather than just programs, achieving that goal is easier said than done.

Many of us have long known that the overhead rates most foundations allow are too low. Funders systematically underestimate what it truly takes to achieve impact, and grantee organizations assume they have to play along. I learned this the hard way as a 20-year CEO of a nonprofit. In all that time, I can count on the fingers of one hand the number of instances a funder specifically asked me what kind of help I might need to strengthen the organization.

Sadly, this communications gap and the other long-standing dysfunctions that the article “Pay-What-It-Takes Philanthropy” describes mean that we know surprisingly little about what kind of funding, for which kinds of activities, delivered at what point in an organization’s life cycle, actually correlates with improved effectiveness, resilience, and durability. Shifting this dynamic will require significant change on the part of both funders and grantees—away from focusing on the success of a grant or program, toward focusing on impact and the role that strong and effective organizations play in achieving that impact.

As the article notes, the Ford Foundation is one among a number of foundations working to make this shift, and it is harder than it sounds! What are we doing, and what are we learning as we go?

In refining our program strategies to focus on reducing inequality, we saw that strong grantee partners are essential to the impact we seek—particularly because of the nature of what our grantees do. In working to disrupt the forces that produce and reproduce inequality, every success they achieve is likely to cause a counter-reaction. It is essential that they have the capacity to be nimble, strategic, and adaptive so that they can adjust to this kind of pushback.

Are we doing all that we can to help them? 

We pride ourselves on being a grantee-focused funder with long-standing relationships and frequent use of general support and capacity-building grants. Yet when we looked at data on our patterns of investment, we saw a gap between our self-perception and reality. While our relationships with individual grantees were long, the great majority of our grants were one-year, project-oriented, and small. This kind of funding made it difficult for grantee partners to have the confidence required to make multiyear investments in themselves—be it hiring staff; strengthening their technology, development, or strategic communications capacities; or improving the diversity, equity, and inclusion of their staff and boards.

In our new strategy, we aim to shift how we work with our partners by giving them the kind of trust, flexibility, and additional support they need to do their best work. With every grant we make, we’re asking ourselves not only, How will this help disrupt inequality? but also, How will our support make this organization stronger? We are doing this in three ways that redefine our overall approach for grantmaking:

• Making more multiyear, general support, and capacity-building grants among all our grantees.
• Doubling our overhead rate on project grants to 20 percent—even though we recognize that this is a very blunt instrument and only one step on the path to a differentiated overhead rate based on indirect or full costs.
• Launching a focused effort to help key institutions and networks build stronger financial and organizational foundations through our new BUILD initiative, a $1 billion commitment over five years.

Not surprisingly, the BUILD initiative has attracted a lot of attention. One billion dollars is a large sum, but it could easily be stretched too thin when you think about it as a global effort. So we are humbled as we begin to develop plans with our partners and recognize that most of our investments are more likely to be catalytic than transformational.

We have much to learn from others and have quickly come to realize that even as a funder that is “all in,” we face a number of implementation challenges. For example, how can we make sure we do no harm, knowing that moving in this direction means we likely will fund fewer grantees? How do we break our own addiction—let alone that of our grantees—to funding activities, rather than impact? How do we ensure meaningful learning that will add to and enhance the existing thinking and research undertaken by our peers?

Our goal is to better understand what kind and level of support will make a critical difference to an organization, and learn from that. Likewise, by agreeing to this intensive support, partner organizations are committing to work closely with us, to grow and to learn together, and to share this knowledge across the philanthropic sector. In the process, we hope to help build resilient organizations that are equipped for the sustained effort of challenging inequality.

Hilary Pennington is the Ford Foundation’s vice president for Education, Creativity, and Free Expression. She leads the foundation’s work on school reform in the United States and higher education around the world, next-generation media policy and journalism, and support for arts and culture.

J McCray & Kathleen P. Enright

Chief Operating Officer of Grantmakers for Effective Organizations | Founding President and CEO of Grantmakers for Effective Organizations

Caps on Indirect Costs Are a Misguided Invention

There are four things all funders can do to help the sector move away from obsessing over indirect costs. Segmenting the sector and setting benchmarks isn't one of them.

The obsession with indirect costs and the quest to find the perfect indirect cost ratio has sent foundations and other donors down a dangerous path. Those of us who manage organizations find it to be a meaningless metric. In fact, some of our favorite kinds of costs are indirect: investments in technology, talent development, benefits, evaluation, and fundraising, to name a few, are what enable the highest performing organizations to make incredible breakthroughs.

The indirect cost ratio is perceived to be a simple way for funders to understand whether a nonprofit is making efficient use of its dollars. Yet it’s folly to try to boil efficiency down to a single number. Understanding nonprofit finance is far more nuanced and contextual.

Years ago, when we developed a financial dashboard for our board, we included meaningful measures such as our liquidity ratio and months in cash. Then, we dutifully added an overhead cost ratio. Our board members, some of the most thoughtful leaders in the field of philanthropy, immediately made us remove it because it told them nothing about our organization’s financial health or efficiency. Furthermore, they told us, it could do harm by sending a subtle message to our leadership to avoid investing in our own effectiveness.

It’s broadly accepted at this point that efforts that rely heavily on overhead ratios to rate nonprofits are inherently flawed. Our sector needs to evolve. Some funders have already taken important steps toward providing appropriate financial support to nonprofits. Here are four things all funders can do to help the sector move away from obsessing over indirect costs.

1. Get rid of caps on indirect costs. It’s time to leave the indirect cost ratio on the trash heap of misguided inventions, like trans fats and asbestos. The authors of “Pay-What-It-Takes Philanthropy” have done a fabulous job demonstrating why indirect costs are a problematic way of understanding whether a nonprofit is worthy of investing in. As they point out, “higher or lower is neither better nor worse.” Furthermore, “these figures are not measures of either effectiveness or efficiency.” We strongly disagree with the authors’ conclusion, however, that we need to develop industry standards by segmenting the sector and then setting benchmarks. Given that the indirect cost ratio has so little bearing on effectiveness or efficiency, studying it further won’t be of any benefit to the sector. There is actually an inherent risk in doing this—funders may be tempted to once again use it as a rationale for determining the “right” cap to place on indirect costs.
2. Change the default setting in philanthropy to general operating support. We agree with the headline of the piece. Funders should pay what it takes. General operating support grants, oddly, get short shrift in the article. First, say the authors, nonprofits need to understand what “best-in-class execution costs to allocate general operating funds to highest-impact use.” We call foul. A well-managed organization understands exactly what it takes to deliver its key programs, regardless of the restrictions placed on its revenue. Operating grants give an organization flexibility to direct dollars to its highest impact activities and to change course when there are inevitable changes in the environment. Funders should start with the presumption that all grantees will receive general operating support funds and program grants must be justified. Program grants have their place, but these should only be in instances where you can’t reasonably make the case that the work of an organization directly fits the mission of the foundation. Program grants must, of course, cover the full costs of the program.
3. Fund in other ways that support resilience. Funders need to get in the habit of making larger grants. We see many funders spreading their grants thin across many organizations in what has become known as “peanut butter philanthropy.” This forces grantees to raise lots of small grants from multiple funders, and translates into much higher fundraising costs for nonprofits. We’ve also noticed a tendency among some funders to make nonprofits take turns, because the thinking goes that it will prevent nonprofits from becoming too dependent. As a result, money doesn’t necessarily follow success. This actually makes high performing organizations less stable. A funder that spends more time analyzing which organizations are best suited to their goals, and less time managing lots of small grants, not only has a far greater impact on these organizations—it actually stands a chance of fully supporting the cost of the work it is funding.
4. Help funders and nonprofits alike develop a deeper understanding of nonprofit finance. There are no shortcuts when it comes to understanding if a nonprofit is effective or financially stable. Groups like Nonprofit Finance Fund and GuideStar are developing meaningful measures of nonprofit financial health that help funders and donors get the full financial picture of an organization. An example is the Financial Scan instrument, which relies on a number of measures to understand a nonprofit’s finances.

It’s time to jettison the focus on indirect costs and stop sending a signal to nonprofits that they should scrimp on investments in what it takes to achieve high performance. Instead, both funders and nonprofits should spend more time understanding and investing in what it takes to succeed in the complex work of social change.

J McCray (@jbeattymccray) is chief operating officer of Grantmakers for Effective Organizations, where he has led the organization’s fundraising, strategy development, and operations for more than a decade.

Kathleen P. Enright is founding president and CEO of Grantmakers for Effective Organizations, where she has led the growth of the GEO community and the movement for smarter grantmaking that enables nonprofits to grow stronger and achieve meaningful results.

Jacob Harold

President and CEO of GuideStar

Don’t Oversimplify, Categorize!

It's important that we continue to collect data that can help us sort nonprofits into meaningful groupings.

Categorization can help us make sense of the world: A family sorts its mail, an investor allocates among asset classes, and a child organizes her candy after Halloween.

In “Pay-What-It-Takes Philanthropy,” Bridgespan’s analysts make a compelling case that before we can meaningfully benchmark nonprofits’ program and indirect costs we need to sort organizations into segments. The nonprofit sector is too big and too complex for us to compare all nonprofits in a single group.

The “overhead myth”—the misguided idea that nonprofits’ performance can be judged by accounting ratios—has many flaws. Perhaps the biggest flaw is this: Nonprofits differ wildly from each other. It is incoherent to compare financial ratios between a university with a billion-dollar endowment and a homeless shelter.

This article offers a new way of thinking about comparisons among nonprofits. The four categories it offers are only a beginning. The authors rightly call for more research to build out a robust taxonomy of nonprofit business models.

The timing is good. The nonprofit field is rethinking the ways it categorizes itself. Existing frameworks—for example, the National Taxonomy of Exempt Entities—have provided an important foundation, but we must work to reach the next generation of nonprofit categorization. The Foundation Center has offered the Philanthropy Classification System as a new, multi-axis kind of taxonomy for philanthropy. Recent work by GuideStar to create a categorization of nonprofit performance metrics (the Common Results Catalog) offers another layer of richness to how we understand the actual work of nonprofits.  

Our challenge as a field is to connect the kind of financial categorization offered in this article with our growing store of programmatic and operational information. With work, we will be able to present nonprofits as more than lists of EIN (employer identification numbers) numbers and context-less financials. Instead, we can explore organizations within natural groupings such as art museums or environmental advocacy groups. (The right taxonomy need not be a perfect taxonomy—it is okay to have a big group for “other”!)

Many of GuideStar’s users and partners have called for a simple star-rating system for nonprofits. We resist those calls. As a field we must avoid oversimplification. Let us talk about nonprofits in a multidimensional way—and within appropriate categorizations. Nonprofits are complex entities and deserve to be understood as such. Humanity has proven itself capable of making complex, multidimensional decisions in other arenas of life: We do it all the time when buying a house or planning a vacation. Let us do the same when it comes to nonprofits.

To do so, we need help. Nonprofits need to be willing to share the data necessary to tell a multi-dimensional story. At GuideStar, we gather and disseminate information about every single IRS-registered nonprofit organization using the 990 form as our foundational data source. But we also ask nonprofits to voluntarily share additional data about programs, operations, and finances by updating their own profiles. To date, 115,000 have given us some additional data, with 37,000 providing enough data to earn one of our transparency seals. In May we launched the newest seal level, Platinum, for organizations that share quantitative programmatic data. Just like indirect costs, programmatic data is most meaningful when we categorize organizations not by their tax status, but by the nature of the work they do.

This is no small task. What we’re talking about will take a decade or longer. But as this article shows, we are making progress in how we understand the complex work of social change. Natural categories that reflect the diversity of the nonprofit sector can help us offer meaningful, contextualized data. And that can drive more giving, smarter giving, and a more effective field.

Jacob Harold is the president and CEO of GuideStar, the largest source of information about nonprofits. He has worked as a grantmaker at the Hewlett Foundation, a consultant at The Bridgespan Group, and a climate change campaigner at Rainforest Action Network and Greenpeace.

Roger L. Martin

Professor at the Rotman School of Management, University of Toronto

Overhead Sounds Useless, So Stop Calling It That

Businesses don't distinguish between direct and indirect costs on price tags. Why should nonprofits?

It is nice that the authors of “Pay-What-It-Takes Philanthropy” mention my critique of the idea that foundations should fully fund all indirect costs: I believe that is a losing battle. However, it feels strange for the authors to mention the critique one page into the article and then spend the rest of the article arguing for the full funding of indirect costs.

There is a powerful reason that funders cap the reimbursement of overhead or indirect costs at a low level. It is because the characterization of these costs (as “overhead” or “indirect”) establishes them as not relevant to the object of the funders’ investment. The grantees willingly collude with the funders to create two classes of costs—relevant and compelling “program costs” and irrelevant and useless-sounding overhead/indirect costs. The funders want a particular program to happen, so they fund the program. Then they are brought a bill for costs that sounds like something they shouldn’t want and, because of that, they don’t particularly want—overhead/indirect costs—and are asked to pay for it. They don’t want it because it is characterized as something completely distinct from their desired thing—the program.

It is like asking a restaurant guest to pay for the meal and then in addition pay an administrative fee of 40 percent for the restaurant furniture, fixtures, taxes, utility bills, location, and view. Obviously the guests would balk when the two pieces are characterized that way. Instead, the restaurant defines the “program” to include the infrastructure and ambiance, not just the food, and it structures its prices accordingly.

I have shown elsewhere (“Rethinking the Decision Factory,” Harvard Business Review, October 2013) that the entire world of business is shifting from direct costs to indirect costs. In business, the former are costs of goods sold—purchased inputs, direct labor, etc.—and the latter are sales, general, and administrative expenses, which include items like R&D, marketing, and talent development. Over the past 30 years, SG&A has nearly doubled from 13 percent to 24 percent as a percentage of revenues of the 30 companies comprising the Dow Jones Industrial Average. Is this a bad thing? No, it is a reflection of the ability of these companies to make their offerings more compelling by adding value to the direct costs—for example, by doing more R&D to produce a more advanced product, or doing more advertising to build a stronger brand.

When selling their products, America’s best companies don’t tell customers that the product costs $76, but they would also like them to pay a $24 indirect cost premium. They say, "That will be $100, take it or leave it." And they don’t attempt to pacify investors by keeping sales costs, R&D spending, and advertising costs at a bare minimum. Their job is to figure out a productive way of producing a high-quality product that customers adore. And the answer as to how to do that, from America’s most prominent and successful companies, has been to dramatically increase investment in what foundations would call “non-program costs.”

This is not a semantic question—it is a strategy question. Currently, funders and grantees are following a losing strategy of suppressing investment in what the most successful organizations in the country are expanding. The only folks who are suffering are the people they are both attempting to help. It is always thus: Customers are hurt the most by flawed strategy.

Roger L. Martin (@RogerLMartin) is a professor and the former dean of the Rotman School of Management at the University of Toronto. He is a coauthor of Playing to Win (Harvard Business Review Press, 2013).

Sister Paulette LoMonaco & Greghan Fischer

Executive Director of Good Shepherd Services | Chief Administrative Officer and CFO of Good Shepherd Services

Government Needs to Pay-What-It-Takes, Too

For many nonprofits, government funding caps for indirect costs pose even more of a challenge than similar caps at foundations.

Although the “Pay-What-It-Takes Philanthropy” article rightly highlights the need for foundations to step up and reimburse a nonprofit’s true indirect costs, foundations aren’t the source of our biggest financial challenge. For Good Shepherd Services, under-resourced government contracts do us far more financial harm.

Good Shepherd Services is a large human services provider in New York City. We operate nearly 90 programs that help more than 30,000 young people and their family members in struggling neighborhoods throughout city. We’ve been fortunate to work with foundations—Edna McConnell Clark and The Clark Foundation, to name two key long-term supporters—that have provided us with the general operating support we need to build our capacity. It’s rare for nonprofits to find a foundation that will provide general operating support and allow it to be used where it is needed most. But it’s even rarer to find a government agency that covers the full cost—both direct and indirect—of the services for which it contracts. We have more than 150 government contracts, and because of that we need to raise 20 percent of our approximately $88 million budget privately, an enormous gap that we struggle to fill each year.

Our new federal indirect cost reimbursement rate is 17.2 percent—the highest among our government contracts. Why? Because we have a very robust program evaluation and training department, and we manage by using data. That is what it takes for an agency committed to utilizing evidence-based and evidence-informed practices to manage more than 150 government contracts. By contrast, the New York State Legislature has imposed an overhead cap of 15 percent on state social services contracts. But our biggest challenge is New York City, where contracts traditionally have never exceeded 10 percent for overhead, and many have paid less.

Fifteen years ago, government contracts received regular adjustments to reflect the increased costs of doing business. At that point, 10 percent was doable. Since then, emphasis has shifted dramatically toward compliance, evidence-based programs, and valuable, but costly, program evaluations. All of that demands sophisticated databases and technology. In addition, providers of evidence-based programs must ensure specific implementation and model-fidelity standards, which requires creating new administrative capacity and on-going training that are enormously costly. Now 10 percent comes nowhere near our true expenses. Low fixed-overhead rates are destabilizing to nonprofits like Good Shepherd Services, and the services we provide, whether they come from government or foundations.

The city government contract climate has become so unfavorable that increasingly we and others pass on contracts that don’t provide sufficient indirect reimbursement for the quality of the work needed to meet our bar. And Good Shepherd Services is not alone! In response to a recent procurement for a youth employment program, agency after agency declined to apply because of insufficient funding for administrative costs.

To make up for the shortfall we experience from government contracts, Good Shepherd Services engages in a number of intensive fundraising activities. We gratefully accept general support funds from our donors. We organize two gala dinners and two golf events each year, and we use our monthly newsletter and web site to appeal for support.

Solving the problem of low, fixed overhead reimbursement rates won’t be easy. It is made more difficult by the lack of a standard definition of overhead or indirect costs. One first step to address this problem is for all stakeholders in the field to agree to a clear and shared definition of indirect costs.

The need to direct private fundraising dollars to cover un-funded costs in government contracts stymies Good Shepherd Services’ ability to continue our long history of innovation. We have had the distinction of creating program models that have been replicated in New York City and across the country. For example, we started the Transfer High School model to re-engage students who have dropped or fallen behind. It became a core model in the Bloomberg Administration’s high-school graduation strategy that led the Bill & Melinda Gates Foundation to fund Good Shepherd Services to codify the model for national replication. We believe that there are many other new models that need to be created to serve our population well, and we are eager to do this! But when we have to use our unrestricted money to fill the gaps left by government contracts, we can’t afford to innovate and create new models to meet today’s needs. That is a real tragedy.

Fortunately, nonprofits in New York City are organizing to amplify their concerns about insufficient government contracts. The Human Services Council of New York, which represents hundreds of New York City nonprofits, is taking the lead to form a committee that will create a rating scale—red, yellow and green—to signal whether city contract procurements meet acceptable standards, including coverage of indirect costs. This will help all nonprofits make better contracting decisions and encourage government to improve. Rating contracts is a whole new frontier for nonprofits. But we hope it’s an important step to breaking the grip of the “starvation cycle” that jeopardizes the work of so many social services agencies.

Sister Paulette LoMonaco is Good Shepherd Services’ executive director, and Greghan Fischer is chief administrative officer and CFO.

Jeri Eckhart-Queenan & Michael Etzel

Partner and Head of Global Practice at The Bridgespan Group | Manager at The Bridgespan Group

Pushback, New Thinking, and Next Steps

Last Word: Jeri Eckhart-Queenan and Michael Etzel respond to the comments on their article.

We have been gratified by the tremendous amount of support we received for our Stanford Social Innovation Review article, "Pay-What-It-Takes Philanthropy,” but we’ve also gotten some pushback. In fact, if we were writing the article today, we’d do some things differently to reflect how our thinking has evolved. No doubt our thinking will continue to evolve as we push toward new solutions.

Nonprofit leaders across the United States and abroad have let us know that the article really hit home. They like it because the article clearly establishes that indirect costs are real and that the typical 15 percent funder reimbursement rate is too low. We have been told that the article is being circulated among nonprofit boards as a must-read. For those nonprofits with business models that rely on a higher mix of indirect costs, the article is particularly valuable because it helps to validate their costs and has been used in making their case to funders.

The pushback has come from some funders who disagree with our emphasis on the need for nonprofit segmentation and benchmarking. They fear that segmenting nonprofits by activity and benchmarking expenditures will lead to replacing today’s low caps on indirect costs with new caps that are just as misguided. In the critics’ view, the sector should scrap indirect costs altogether and focus instead on providing general operating support.

They have a point. We acknowledge that we gave general operating support short shrift in the article. We’d argue today that funders ought to supply flexible, multiyear funding to grantees they trust, accompanied by open and honest conversation about the nonprofits’ true needs, encouraging nonprofits to make investments in innovation, impact, and efficiency that “but for” this capital they would not make. Unrestricted funds are the most valuable type of capital for nonprofits because they allow them to grow stronger.

But general operating support by itself is unlikely to solve this problem of underfunding indirect costs—dubbed the nonprofit starvation cycle—given that US foundations, the US government, and many global funders give the vast majority of their funds through project- and program-specific grants. It’s unrealistic to think that all funders would ever go to providing 100 percent general operating support. In a world where billions of dollars are being awarded as project support grants, nonprofits should not have to re-set expectations of indirect cost levels—which are inherent to their business models—one by one, funder by funder, or grant by grant. That’s why we believe that segmentation and benchmarking have an important role to play in solving the current problem with project grantmaking.

In the corporate world, we have learned that CEOs and leadership teams really value segmentation and benchmarking for what it tells them about their own cost structure, how they compare to peers, and how to allocate scarce resources to the highest and best use. That’s what segmentation and benchmarking can tell you. It’s extremely valuable information. Not to pursue segmentation and benchmarking in the nonprofit arena out of fear that the information might be misused is shortsighted. Every nonprofit leader should want to know this information.

Our commitment to better understanding segmentation and benchmarking continues as we carefully examine the expenditures of a greater number of nonprofits. Beyond our ongoing research, we see a need for sector leaders to come together to craft shared language and definitions. Today, terms like overhead and indirect costs mean different things to different people.

We also will work with nonprofits and funders to coalesce around a common point of view about how best to fully fund nonprofits. We’ll never solve this problem if key stakeholders get stuck on planting the flag on their own turf. We need shared, scalable solutions.

Finally, we understand that the conversation about indirect costs is just a piece of a much larger conversation about funding and how nonprofits achieve impact and scale. That larger conversation includes the need for nonprofits to understand their full costs, the role of general operating support and multiyear funding, and the importance of capacity building.

Make no mistake. This is hard work. But it’s important work for the social sector to embrace and advance. We’re eager to join with others on this journey and to contribute what we can.

Jeri Eckhart-Queenan is a partner in The Bridgespan Group’s Boston office, where she leads the Global Practice. She is the coauthor of “Stop Starving Scale: Unlocking the Potential of Global NGOs,” Bridgespan.org, April 2013.

Michael Etzel (@etzel) is a manager in Bridgespan’s Boston office and author of “Philanthropy’s New Frontier—Impact Investing,” Stanford Social Innovation Review, November 9, 2015.