What Does "Real Cost" Mean?
The Real Cost Project aims to shift the focus from overhead to outcomes and what good outcomes really cost. Simply put, the real cost includes all necessary costs for a nonprofit organization to deliver on mission and to be sustainable over the long term. Like any enterprise – including for-profit corporations – nonprofits and social enterprises must be able to cover the real cost of their programs and operations if they are to deliver excellent outcomes. Whether an organization is serving returning veterans, providing health and human services to the most needy, or building vibrant communities, the cost of delivering results includes not only direct programmatic expenses but also the capacity and capital needs of the organization.
The Overhead Question
There has been much written on the idea of nonprofit overhead and whether or not it is a good indicator of nonprofit effectiveness. Our aim here is not to rehash old arguments around the overhead question. In fact, we believe we need to move beyond the overhead question and adopt a new paradigm that shifts the focus of grantmaking from inputs (overhead costs) to funding social outcomes.
One of the biggest challenges around funding for nonprofit overhead is that there is no consistent definition of “overhead” – in fact the term ‘overhead’ is not an official accounting term. To make it more confusing, you may also hear terms such as ‘indirect costs’, ‘administrative costs’, or ‘shared costs’ being used as the equivalent of ‘overhead’.
In the for-profit world, the customer buys the product and pays the fully loaded cost for that product. For example, when you go into your local coffee shop, you don’t restrict how much of your payment can be used to cover overhead or indirect costs. In an article in the Seattle Times, writer Melissa Allison provides a breakdown of the direct costs, indirect costs and profits for a small latte. She shows that only 25%-30% of the price you pay is for direct costs while the rest of your payment goes to cover marketing, administrative, and operating costs along with profits for the coffee shop.
Millions of people have no problem walking into their local coffee shop every morning and paying the fully loaded cost for their latte. However, when it comes to funding organizations working with the homeless, disabled veterans, or children in foster care, these same donors want to limit how much the nonprofit organization can spend on infrastructure and operational support. How long would any for-profit business last if its customers limited the amount of money the company could spend on overhead, operations and profits? Probably not very long. Yet we expect nonprofit and social sector organizations to achieve great outcomes while we continue to starve their organization’s infrastructure and operational needs. Clearly we need a new approach. If we want impact and great outcomes, then we need to begin with an approach that starts with the outcomes in mind, understands what those outcomes really cost and determines what role funders want their money to play.
The Real Cost of Great Outcomes
The real cost of delivering outcomes includes three key elements: Program Expenses, Administrative and Operating Expenses, and Reserve and Capital Expenses.
These expenses are directly attributed to a specific program or project. For our purposes, we will not include “shared” or “allocated” expenses as program expenses, although we recognize for the vast majority of nonprofits and funders those allocated expenses are often lumped in with program expenses. Again, there is no standard definition, but one way to look at it is to ask the question, “If that program went away, does that expense go away?” If yes, then it is a direct program expense. If not, then it is an administrative or operational expense – even if for the purpose of a grant you can allocate a portion of that expense to the program or project.
Administrative and Operational Expenses:
Administrative and operational expenses include investments in an organization’s leadership, infrastructure and operations. These include Executive Director, Accounting, HR and legal, Finance, Marketing and Communications, Fundraising, Insurance, Office management, Investment expenses, Board meetings, Annual reports, and other centralized services. This is also often referred to as ‘overhead’, ‘shared costs’, or ‘indirect costs.’
Reserve and Capital Needs:
One area often overlooked by many nonprofits in calculating their fully loaded costs of doing business is reserve and capital needs. Like any for-profit business, nonprofits also need to invest in long-term sustainability, adapt business models, develop new products and services, and have money set aside for the proverbial “rainy day”. Organizations have a range of reserve and capital needs from current short term needs to long-term strategic investments. Below is a helpful chart from the TDC Group: