Controversy over transparency: why non-profits need to disclose their “real” overhead ratio

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Ryan Jiha

Ryan Jiha

Ryan Jiha is currently Finance Grant Manager at Partners in Health (PIH) in Boston, MA. He has previously served as project manager for Zanmi Lasante (ZL), PIH’s sister organization in Haiti. During his time in Haiti, he has helped build the administrative and project management capacity within ZL for effective healthcare delivery in the areas of HIV/AIDS, Tuberculosis, Water Sanitation and Hygiene (WASH), Child Health, Protection and Nutrition.

“The fact is an average of 91 cents of every dollar the Red Cross spends is invested in our humanitarian services and programs.”[1]

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This is a statement released by the Red Cross, a not-for-profit 501(c)(3) organization, on its website shortly after a special report revealed that over $400 million of the aid money it received after the 2010 earthquake in Haiti was unaccounted for. [2] Being one of the two largest recipients of donor money for disaster relief in Haiti[3],[4] – the other being the United Nations – it should come as no surprise that the Red Cross came under a lot of scrutiny for its use of aid money from US taxpayers.[5] The Red Cross scandal highlighted an often overlooked component of the cost structure of an organization: its overhead ratio. That is, the ratio of an organization’s indirect costs to its direct costs.

According to Richard Siegrist’s definition, indirect costs are “costs not directly traceable to only one cost object.” [6] For a multi-program organization like the Red Cross, indirect costs translate into “program support” costs that are not easily identifiable within a specific program, but which are, nonetheless, necessary for the successful operation of the program. Some examples may include: existing facilities costs (i.e. rent, maintenance, and utilities), depreciation on equipment, communications expenses, insurance, etc. These costs are shared among organizational functions (program, management, general administration) and in many cases may differ from one organization to another. While there are many (generally accepted) ways an organization may want to allocate its indirect costs (see Siegrist, 2013), the most common method for non‐governmental organizations (NGOs) and other large non-profits is to develop an indirect cost rate.

The first step in determining an indirect cost rate is for an organization to separate all costs into two groups: direct and indirect costs. The indirect costs are aggregated into an indirect cost “pool” (or “base”) and then allocated to the organization’s functional departments based on a set rate[7]. Typically, a large multi-program NGO such as the Red Cross, will need two or more indirect cost rates: one for use on grants, contracts, and other agreements with the Federal Government, called a Negotiated Indirect Cost Rate Agreement, or NICRA;[8] and another for individuals and private foundation funding sources.

So why do we need to care about an organization’s “overhead” rate? After all, it is mainly calculated to inform the organization’s management decisions and to fulfill the non-profit’s reporting obligations to government agencies and regulatory bodies (see Siegrist, 2013).

For one thing, an organization’s “full cost” or “true cost” of operation is “a combination of the direct cost […] plus a fair share of the overhead of the institution” (see Siegrist, 2013). In other words, indirect costs are an important variable for an organization’s cost equation in a given year. For many non-profits, the range of indirect cost rates can vary from as low as 0-3% to as high as 51% and more for large multi-program NGOs.[9] Second, and more importantly, because an organization’s “true” indirect cost rate differs largely from the rate disclosed to the donor. For every dollar donated, according to the Red Cross website, 9 cents go to cover program support expenses. However, a recent Senate investigation revealed in a 309-page report[10] that out of the $488 million collected from donors in the wake of the earthquake, the Red Cross spent an “estimated $125 million on management and fundraising expenses and program costs.”[11] Thus, the Red Cross’s “real” indirect rate is closer to 25% than it is to the 9% advertised on its website.

At a time when public opinion on foreign aid is at an all-time low,[12] non-profit organizations need to be more financially transparent about their “real” indirect rate. The Red Cross claims that it is “a not-for-profit organization that depends on volunteers and the generosity of the American public to perform its mission.”[13] It would be a shame to see such a well intentioned non-profit lose the largesse of US households and struggle financially because donors feel deceived by its false advertising. The Red Cross should avoid that scenario at all costs—both direct and indirect.

 

 

[1] http://www.redcross.org/news/press-release/How-the-American-Red-Cross-Spends-Your-Donations

[2] http://www.npr.org/2015/06/03/411524156/in-search-of-the-red-cross-500-million-in-haiti-relief

[3] http://www.csmonitor.com/USA/2010/0712/Haiti-earthquake-Six-months-later-are-relief-efforts-dragging

[4] http://www.people-press.org/2010/01/20/haiti-dominates-publics-consciousness/

[5] https://www.theguardian.com/global-development/2016/jun/19/chuck-grassley-american-red-cross-haiti-aid-money

[6] Siegrist R. Cost Accounting – The Foundation of Management Control. 2013

[7] Calculation of the rate itself involves a multi-step approach depending on which indirect rate the organization wants to find. For federal indirect rates (NICRAs), the following publication explains the three methods accepted by the Federal Government: https://www.dol.gov/oasam/programs/boc/costdeterminationguide/cdg.pdf

[8] Non-profit healthcare organizations doing business with the Federal Government are required to submit a detailed calculation of their indirect costs to the US Division of Health and Human Services for federal grants, which are reviewed and approved for use each year.

[9] taken from the State of the Nonprofit Sector 2014 Survey, showing the average indirect cost reimbursement rates across the nonprofit sector: http://www.nonprofitfinancefund.org/sites/default/files/docs/2014/2014survey_brochure.pdf

[10] http://www.grassley.senate.gov/sites/default/files/constituents/2016-06-15%20Senator%20Grassley%20Red%20Cross%20Inquiry.pdf

[11] https://www.theguardian.com/global-development/2016/jun/19/chuck-grassley-american-red-cross-haiti-aid-money

[12] http://www.politico.com/story/2013/02/poll-most-only-want-foreign-aid-cuts-087948

[13] http://www.redcross.org/news/press-release/How-the-American-Red-Cross-Spends-Your-Donations