OPTIMIZING OVERHEAD RECOVERY IN CHALLENGING TIMES: 10 approaches to adapting to a new landscape Copyright Eric G. Walker July 30, 2013 These are challenging times for non-­‐profit organizations (NPO) when it comes to fully recovering their overhead costs. While most US government funding still pays full audited overhead, many other donors have set rate limiting caps, flat out don’t pay some kinds of costs, and much prefer to see their dollars going to work where the projects are being implemented. Headquarters costs are considered undesirable while field-­‐based costs are well received. To make matters worse, USG budgets are diminishing, and as a result, funding from more restrictive donors is on the rise. NPO overhead recovery models are shifting to lower rates, more costs captured as directly related to project efforts, and overall showing these donors what they want to see. There are multiple ways NPOs can address this changing environment though cost reduction, restructuring, alternative budget presentations, and sometimes even adding their own revenue to offset overhead costs. This paper discusses 10 methods to optimize overhead recovery within the changed environment. 1.
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Reduce administrative costs Maximize direct charging Bill through service centers Directly allocate closely supporting costs Create a network of organizations Reconfigure cost structures Align budgets to donor expectations Subsidize or co-­‐fund Seek grant support for operations Fixed price agreements The first four approaches reduce or shift costs, the next three require a change in structure, and approaches 8 and 9 are designed to increase revenue. The last approach takes a different tack and focuses on the total price of an activity only. These approaches can be used individually or in a mix. In the following descriptions, administrative costs will be referred to as “overhead” and is intended to refer to those costs typically incurred for non-­‐program purposes such as HR, finance, IT, infrastructure, legal, procurement and communication. The addendum shows examples of how each method could be applied in an accounting system. 1. Reduce Administrative Costs The most common first thought in addressing donor concerns about too much of their grant going to non-­‐program purposes is to simply reduce costs that are not considered “program”. This is indeed a valid approach to make sure only recurring costs and those necessary for a high-­‐capacity, sustainable organization are being incurred. It is important to rationalize and regularly re-­‐rationalize all non-­‐
program, i.e. overhead, costs against the NPO strategy and business model. Each classic area of overhead – HR, finance, IT, infrastructure, legal, procurement and communication – hold costs that are optional and can be scrubbed every few years. “Scrubbed” means to examine each cost to make sure a direct line can be drawn from that cost to a strategy or a reputation-­‐essential practice. For example, if a training strategy is to improve compliance to donor regulations, then any staff development efforts should target this end and any others should be postponed until they are in the strategy. Or, if maintaining a four star rating in Charity Navigator is essential for the NPO’s reputation, then any costs to enhance web presence must be tied specifically to maintaining a high transparency score. Any “simply makes us look better” costs should be postponed. Cost cutting as a sustainable approach to build a stream of reliable recurring overhead-­‐recovery funding is difficult. While a reduction in overhead costs will likely lower the overhead rate, in the short run, it likely will exacerbate the attempt to be more operationally cost effective over time. Cost effectiveness comes when an entity spends the same or less for a greater output. Cost cutting alone will lower cost but have no bearing on greater output. Ironically, organizations have to spend more to be able to spend less over the longer term. If two accountants are needed to process payroll and all accounts payable today with a lot of hands on double entry, their work will only grow as transactions increase leading to the need for another staff member. Even if growth does not occur, the number of staff will remain the same. To reduce costs with no growth or to increase output with the same staff during growth, the business processes and most likely the underlying system have to be revamped to gain work flow efficiencies. The existing workers cannot stop what they are doing to evaluate processes, write requirements, evaluate vendors, restructure work flows, and train or be trained. Cost efficiency needed as the precursor for cost effectiveness can only be realized with a special investment usually in a team to work in parallel with the internal staff. Where does this money come from if costs are being cut to lower the overhead rate? 2. Maximize Direct Charging Many value-­‐for-­‐money institutional donors encourage grantees to put all the necessary costs of the project work in the budget as direct costs. Direct costs are costs that can be directly attributed to the project work. For example, if HR staff is recruiting or on-­‐boarding staff for the project, the time they spend can be recorded as a direct cost to the project. As long as the grantee can justify the costs as reasonable and necessary for the specific work of the project, it can be direct charged. In small organizations with a few grants, direct charging of many of the activities of the usual overhead activities – HR, finance, IT, infrastructure, legal, procurement and communication – to program is quite feasible and is a very legitimate approach to a sustainable overhead cost recovery method. The challenges with direct charging appear as the NPO begins to grow. Once the project portfolio includes more than 20 projects, it becomes more and more difficult for usual overhead activity staff to differentiate their time between the many projects. It becomes more efficient to consider the time spent supporting projects as not direct but as “indirect” and charging all the recruiting and on-­‐boarding time to overhead. These indirect costs are now part of what is called the “overhead pool” along with all other typical overhead costs that cannot be attributed to a project. Periodically, often monthly, the total costs of the overhead pool are spread to the projects on a fair share basis. The basis is often the total amount of direct costs already charged to the project, so small projects are allocated a small share while large projects receive a proportionately larger share. This “overhead allocation” is a convenient way for streamlining the charging of typically overhead costs to the projects At the end of the day, the total amount of costs charged to any one project (both direct and indirect) using the overhead allocation method is very similar to the amount that would have been charged if the direct method was feasible. However, there is a time savings with the allocation method as workers don’t have to spend time keeping track of how they support all the projects in some way. It is inherently cost efficient. However, many value-­‐for-­‐money donors are less interested in the bottom line than the ratio of overhead to direct program expenses. Fifteen percent is seen as a level above which these donors see as not cost efficient. This standard is not based on a careful analysis of the trade-­‐offs nor of cost comparisons between organizations nor measures of operations effectiveness. It just is the de facto standard among this group. It is difficult to run a medium-­‐sized NPO within the 15% standard unless a substantial amount of direct charging is taking place. Smaller organization staff can relatively easily parse out their time among their organization’s few projects so that 15% charged to the projects is sufficient to cover the typical overhead costs that simply cannot be attributed to single projects such as general ledger accounting, organization audits, or setting organizational strategy. Larger organizations often reach an economy of scale where the focus of many projects in one area or funding by single donor means support can be efficiently standardized coupled with some degree of direct charging to keep costs within the 15%. The medium-­‐sized organizations are caught in the middle where they are too large to charge out project attributable overhead costs yet too small to realize economies of scale. They need the extra overhead costs like robust strategic planning but do not have a large enough program to bring down the indirect rate. They are caught betwixt and between. Lately, one value-­‐for-­‐money donor the Global Fund for Aids, TB and Malaria (GFATM) has decided that a new standard was needed for their circumstances. GFATM has set a new de factor standard of near 5% down from the previous 12%. This dramatic re-­‐setting of the standard is forcing international development NPOs to change their business model by accommodating to the new standard or leaving this funding source behind. Several organizations are in the process making the change by implementing an aggressive direct charge out regime coupled with several of the approaches that follow. They are using multi-­‐faceted approaches to reach the new standard rather than exit the game. 3. Bill Through Service Centers Portions of typical overhead functions—HR, finance, IT, infrastructure, legal, procurement and communication—are often delivered to program as specific services needed for the implementation of their work. Project teams typically need recruitment, financial reporting, telephone conferencing, legal advice, vendor surveys, editing services and the like that are often available from in-­‐house overhead-­‐
funded teams. By setting up service centers for commonly purchased services, the NPO can shift costs from overhead to direct project costs lowering the overhead rate. Service centers are like very small businesses set up within the NPO. Teams selling the services to projects establish a unit cost price (like an hourly rate,) keep track of the units sold, and bill projects for the appropriate amount. The unit price is set to cover all the costs of the selling team plus a mark up to cover un-­‐billable time such as meetings, staff supervision, etc. The NPO makes an estimate of the services needed for the year and allocates sufficient staff time to the service center for the forecast need. As the service demand varies, the NPO adjust available staff time accordingly. Billing for services rendered through the service center approach works best when there is a clear picture of demand from projects. The demand needs to be reasonably predictable and not too volatile. Ideally, the service center team has a relatively constant flow of work with few stretches of no work. If the demand is variable, funding for the down time periods returns to overhead as team members pick up other overhead work and the service center approach is mitigated. 4. Directly Allocate Closely Supporting Costs Some costs are so closely associated with program work, they are much more like direct costs than indirect costs. For example, a program office in the field that directly supports projects in its own country and neighboring countries can justify charging a reasonable portion of its costs to the projects it supports rather than overhead. Each month the supporting costs can be spread to those projects on a basis that reflects the amount of support. For example, if the program office provides all recruiting and on-­‐boarding work to the areas projects, those costs could be spread to the projects on a new staff headcount basis. This approach is called a “direct allocation” because the costs can be directly attributed to the projects unlike the indirect allocation of overhead costs where the costs are general in nature and not substantially associated with any project. The nature of the HR support work and the proximity of the workers to the benefiting projects strengthen the case for using the direct allocation approach. A commonly directly allocated cost is facilities. Office rent, utilities, security costs and the like are normally accepted by donors as a necessary cost of carrying out programs. Because facilities costs are normally incurred for the organization overall, it is necessary to use some method to allocate them across the organization. One approach is to charge all these costs as overhead and include them in the overhead rate charge to projects. An alternate method is to directly allocate facilities using an appropriate base. If the work of staff is normally one grant per person, then a square foot method makes sense. If staff is particularly matrixed, ie working on multiple grants, then hours worked per grant would be appropriate. Overhead accounts would also receive a share of the facilities allocation as these staff also occupy space that needs to be charged appropriately. In the end, the facilities costs are fairly allocated to program and overhead based on use usually resulting in the majority of costs being charged to program with a lesser share charged to overhead. The facilities costs are shifted from being exclusively overhead in the first approach, to shared on a pro-­‐rata basis between program and overhead. Cost conscience donors may question the direct allocation approach as they will not see a common cost line item like salary or travel but a line reading regional field office. It is important to carefully describe the content of the line item in the budget narrative to help the donor understand the content. On occasion, the particularly cost conscience donor will claim the directly allocated cost as another form of overhead and expect the amount to be covered within the rate ceiling. 5. Create a Network of Organizations A structural approach to dealing with multiple and very distinct donor restrictions on overhead is to separate the NPO into a multiple-­‐organization network joined by a common purpose. This family of organizations approach allows for separate cost structures per entity that are matched to the needs of each restrictive donor. For example, if one donor insists on paying 10% overhead while the NPO’s actual rate is 20%, a separate affiliate NPO can be set up to run more efficiently within the 10% ceiling while the parent NPO continues to run at 20%. While the network of organizations approach is an elegant solution on the surface, there are several major challenges to this approach. First, the entities must be tied together or networked to assure a cohesive mission and common image of the original NPO. Without a common bond of purpose among the entities, the NPO runs the risk of inadvertently spinning off organizations interested in other pursuits or in a worst case creating a competitor. The second challenge is that the typical overhead functions for each separate entity must be kept at arm’s length from the others. If one of the entities provides overhead services to the others or the entities share overhead services in some way, the NPO runs the risk of all the operations being collapsed into a single construct with a single overhead rate applicable to all entities defeating the original purpose. This risk is particularly acute when the parent NPO holds an indirect cost rate agreement with a US government agency which looks carefully across affiliated organizations in applying their fair share doctrine. This doctrine requires that overhead costs be equitably shared with all projects, programs, or activities benefitting from the overhead services. The third challenge is high transaction costs. It is expensive in both time and money to establish and maintain a network of affiliated organizations. There is substantial additional governance cost necessary to maintain multiple boards of directors and extra effort required to keep the network mission cohesive. The benefits received from the multiple-­‐organization construct have to outweigh these transaction costs. The network of organizations approach is viable only when the donor restrictions cannot be mitigated using other approaches and the amount of the new, overhead restrictive funding is substantial. It is normally less costly to co-­‐fund the overhead (see Subsidize or Co-­‐fund below) of a restrictive donor grant than to build a new, complicated affiliate structure. However, if the grant is so large that using limited unrestricted funds is not feasible or not strategic, the network approach becomes a viable financial option provided that the NPO is ready and willing to seriously address the challenges spelled out above. 6. Reconfigure Cost Structure Donors often construe that a row on a proposal budget labeled “overhead” includes only items not related to program at all such as the general ledger accountant or the office manager. In fact, most NPOs include a variety of costs in their overhead accounts that do have some connection to program and are using the overhead accounts to streamline the allocation of those costs equitably out to projects. Many of the approaches above suggest moving those costs out of the overhead accounts, but an alternative is to keep them in overhead but organize them into a set of donor understandable pools. The separate pools prompt a conversation with the donor about what makes up overhead and can lead to the donor accepting costs collected as overhead but shown as a specific form of support to program. This approach is most useful when the NPO has both donors that have no issues with the rate per se such as most US government agencies, and donors concerned about rate. Keeping the accounts in overhead (rather than treating them as direct costs as described above) allows the NPO to benefit form the streamlined allocation approach and to differentiate costs for those donors concerned about rate. Costs incurred in the field, ie where the program work is carried out, are often understood by donors as not costs generic to the organization but costs they are willing to support as part of the program funding. By dividing the field-­‐based or the in-­‐support-­‐of-­‐the-­‐field costs into an overhead account named “Field Support” and explicitly showing that account in a proposal budget expands the donor’s awareness beyond the idea that overhead is simply generic costs. When asked about this overhead category, the NPO staff can explain the way these costs directly support the project in the field and often satisfy the donor that these costs should be covered. Other overhead re-­‐configuration accounts should align with the NPO-­‐funded work and prompt a conversation about content the donors would want to talk about. For example, an NPO partnering with a number of other organizations on a regular basis might consider a “partner support” account, or a research NPO could establish a research support category. A “program support” category while more general would at least steer the donor toward recognizing that overhead activities are indeed in support of the NPO mission too. In order to clearly justify the costs included in the break out account, the NPO has to collect actual overhead costs according to the break out by setting up and using account codes on time sheets and cost allocation vouchers. It is common for donors to inquire about what is actually included in these new accounts and in rare circumstances ask for a financial review or audit of the contents. A challenge in reconfiguring the overhead cost accounts is whether the amount in the break out account is seen as too large by the donor relative to the rest of the budget, and whether the NPO can sufficiently explain what the support specifically delivers to the program. Because these costs accounts are still part of overhead and allocated along with all other overhead, there is not a direct cost-­‐for-­‐cost relationship between the amount and what is actually supporting the project. It is by design a reasonable estimate of the support provided from the overhead accounts. If the allocation is large relative to other costs, donors have trouble accepting the reasonable estimate argument. 7. Align Budgets to Donor Expectations Like the restructuring of overhead accounts, award budgets can also be structured to meet or be more consistent with donor expectations. While some donors publish budgeting guidelines that spell out exactly how they want to see overhead presented in the budget, others do not. The NPO can find out through conversation with the donor representatives their norms, do’s and especially the don’ts. One class of donors is very specific about the principles of overhead, i.e. what is included, how the rate is computed, while another class focuses exclusively in the rate being not higher than its ceiling. The first class, let’s call these “class I”, explains the underlying rules and processes for computing an overhead rate and expects these to be followed in determining the rate applied in the budget. They also require an annual audit of the NPO processes to make sure the principles are being followed and the rate computation is correct. US government agencies typically follow this approach. The overhead rate in a proposal is accepted or not based on whether the proper procedures were followed rather that the size of the rate or methodology used to compute it. The second class of donors, “class II”, focuses almost exclusively on the rate itself. These donors typically set a rate ceiling above which they will not fund. It is that simple for them. US private foundations typically use this approach. In order to satisfy both classes of donors (and a host of in between types), the NPO must adapt the cost presentation to the donor to meet their expectations. If an NPO has an overall overhead rate of 20% (5% field support costs and 15% general costs), and is preparing a proposal to a class I donor, the cost proposal budget can show the full 20% in an overhead line below the project costs subtotal assuming the NPO has followed the donor’s prescribed method for determining the rate. If the NPO is preparing a proposal to a class II donor who has an overhead ceiling of 15%, the cost proposal budget should show the field support included in the project cost subtotal before adding in the 15% general overhead amount. The following figure illustrates the two approaches. CLASS I
Personnel
Travel
Supplies
Communication
$
100,000
15,000
2,500
7,500
Subtotal
125,000
20% 25,000
150,000
Overhead
CLASS II
Personnel
Travel
Supplies
Communication
Field support
Subtotal
Overhead
$
100,000
15,000
2,500
7,500
6,250
131,250
15% 18,750
150,000
Each budget meets the expectation of the donor, shows the same total costs, and is a legitimate approach. The primary challenge in using this approach is the additional transaction costs of reporting back to multiple donor types according to the structure of the budget originally presented. The NPO’s books of account should be kept using a single consistent method for spreading overhead costs across all projects. Typically NPOs with class I donors keep their books of account in a way to meet those donors annual audit requirements which is often not the same as what might reflect the agreement with the class II donors. The preparation of class I donor reports is a relatively straightforward process of reporting expenses against the project as they appear in the core account records. However, class II donor reports are not as easily prepared. They are based on the core account amounts but are reconfigured to match the format of the agreed upon budget format. Each time the NPO agrees on a different class II donor format, additional work will be required over the life of the project. 8. Subsidize or Co-­‐fund In addition to cost and structure approaches to optimizing overhead coverage, there are revenue approaches as well. NPOs always have the option of using unrestricted funds to pay directly for a portion of overhead costs that would normally be allocated to projects thus lowering the amount covered by donor awards. If NPO’s donors have an overhead rate ceiling below the actual running rate of the NPO, the overhead expenditures can be subsidized by applying revenue to them before computing the rate applied to all projects. An alternative means of reducing the overhead charged to the donor is to use unrestricted funds to co-­‐
fund all or a portion of the overhead costs allocated to a single project. In the case where a value-­‐for-­‐
money donor is very restrictive in its overhead rate, it may be necessary to apply unrestricted funds as revenue to the project they fund if the NPO cannot lower its actual overhead rate to the low standard level using other methods. The amount of applied revenue is equal to the overhead funding shortfall for that project. The single project case prompts the need to explain a key principle that comes into play in internally allocating overhead to projects. Overhead must be spread across or allocated in the same manner to all projects of the NPO in the core books of account. It is inappropriate according to this consistency principle to allocate overhead to the projects according to the donor’s ability to pay. For example, it would be inconsistent to allocate 5% to a GFATM project while increasing the allocation % to other funders to make up for the shortfall with GFATM. In the accounting records, the overhead allocation must be consistently computed according to the organization’s stated approach. If the NPO has an overhead rate of 12% it must apply 12% to the GFATM-­‐funded project as well as all other projects. Subsidizing organization overhead can be used as a strategic approach. Some NPOs with strong bases of unrestricted giving may choose to consistently subsidize a substantial portion of their overhead expenses to “buy down” their overhead rate to a level they believe is strategically important to maintain. 9. Seek Grant Support for Operations A second revenue approach is to seek grant funding for general operating support or for one-­‐time specific capacity improvement efforts. A small but growing number of class II donors are willing to supplement their limited overhead rate ceiling with specific purpose grants directed toward covering operations. These operations support grants are often directed toward improving the capacity, people or systems, of the NPO. The funding is not intended to be long term, but for defined periods of time to uplift the NPO to a more sustainable plateau. This revenue is used to offset what would be considered overhead costs with revenue to keep the rate low (see Subsidize or Co-­‐fund section above.) Donors are beginning to have a new appreciation for operations uplift grants as evidenced by the latest GEO study mentioned in the opening of this article. This new interest is about building sustainable, healthy NPOs. If the NPO has a plan for systems uplift or talent development that can be written as a grant proposal, more and more donors are willing to consider results-­‐driven efforts to improve operations. One NPO has recently reported securing a matching grant to cover specific systems improvement efforts provided that the NPO raises funds from other sources as well for the same purpose. Another example is a broader, multi-­‐year institutional support grant to hire more capable leadership staff, reach out to more diverse communities, and to establish a matching fund for new unrestricted contributions. The underlying assumption is the NPO will be able to expand its funding base over the period of the grant and generate additional overhead revenue to cover the recurring new costs by the end of the grant. 10. Fixed Price Agreements A final approach that can be very time and systems-­‐change efficient is to negotiate a fixed price agreement where the donor agrees to pay a fixed amount for the delivery of a specific service or set of services. The question of overhead recovery is moot because the value of the service delivered is set by the price negotiated. The seller (the NPO) sets a price that it expects will cover all costs to deliver the service. The buyer (the funder) decides whether the price is fair. Once the service is satisfactorily delivered, the price is paid in full. While the question of overhead is eliminated, the NPO accepts the risk of being able to deliver the service for the negotiated price. If the service is delivered for lower than the price, the NPO comes out ahead and the surplus is kept as unrestricted income. However, if the cost to deliver the service is greater than the fixed price, the NPO incurs a loss and cannot go back to the funder for additional funding. Fixed price agreements are often used in smaller projects where the services to be delivered are clearly delineated. For example, a funder who would like an NPO to deliver a set of services, to be determined over time, may elect to negotiate a fixed price for each task as it arises. The key to optimizing overhead recovery is to know your donors and work to increase their understanding of the role overhead recovery methods play in building high performing and sustainable NPOs. Donors come from a philanthropic perspective where maximizing impact or at least achieving results is the order of the day. While some donor groups acknowledge that strengthening grantees is important too, making the case for investing in the NPO is still more the norm. There is no better way to advance this discourse than to hold regular face-­‐to-­‐face meetings with the NPO donors on the topic of funding operational effectiveness through a regular means of paying for cost effective overhead functions and periodic investments in upgrading NPO capacity. ADDENDUM – Examples of 10 Methods