Accounting provides some measure of a firm's economic efficiency on its income statement. A large net income usually tells us that something has gone right, while a large loss indicates that something is amiss. The same cannot be said about a non profit's income statements (usually called the Statements of Revenue and Expense). Since the central goal of a non profit is to provide services, not earn large profits, the absence of a profit is not a mark against the organization. As an alternative to the income statement, accounting attempts to measure a non profit's efficiency on a financial statement called the Statement of Functional Expenses (SFE).
The SFE divides a non profit's expenses into three categories:
1.Program Expenses: goods and services distributed to fulfill the purpose of the organization.
2.Administrative expenses: costs of business management, record keeping, budgeting, and finance and other management and administrative activities.
3.Fund raising expenses: costs of fund-raising campaigns and events.
The underlying idea of the SFE is that an efficient non profit is one that minimizes its cost of fund raising and administration. The SFE allows us to compute the ratio of these three expense categories. We might reasonably expect that an organization that spent 80% of its resources on program, 15% on administration and 5% on fund raising would be more efficient than an organization that spent 80% of its resources on fund raising, 15% on administration and 5% on program related expenses.
In theory, we should be able to compare the efficiency of various non profits by comparing the expense ratios reported on their SFEs. Alas, these reported ratios are not so reliable because non profits tirelessly diddle the accounting rules and definitions as to what constitutes a fund raising expense versus a program expense.
The Big Fudge: Joint Fund Raising and Program Costs
The idea of joint costs is to partially disguise fund raising costs as program costs. Traditionally this is done in large direct mailings by enclosing a newsletter or a call to action with the fund raising appeal. The enclosed newsletter allows organizations to claim that the cost of the mailing is at least partially attributable to education (a program function). Or the enclosed call to action is part of the organization's advocacy work (also a program function).
Example. Onandon is a charitable group devoted to assisting traumatized victims of over talking. In addition to providing support and treatment groups, the organization supports legislation to combat over talking in the society at large. They annually send a 10,000 piece direct mailing that cost them $25,000. In the mailing, along with a request for funds, they include a newsletter and an appeal to supporters to contact their congress person to vote for a reform law that would limit the length of election campaigns to three weeks. They expect to collect $40,000 from the mailing. So after costs they net only $15,000 on the mailing. If the cost of the mailing is fully allocated to fund raising expense it would appear that only 38% of raised funds go to program purposes ($15,000/40,000). On the other hand, if they divide the cost of the mailing equally between fund raising and program expense then the ratio looks much better. Now it would appear that 75% of the funds raised go to program purposes ($15,000/$20,000).
What the Accounting Rules Say about Joint Costs
Accounting rule makers have made sporadic attempts to close this obvious loophole. The latest rules still allow organizations fairly broad discretion in fudging fund raising costs. One restriction that cannot be circumvented is the use of paid fund raisers. If a fund raising campaign uses paid fund raisers paid on commission then the entire cost of the campaign must be classified as fund raising expenses. Other than that restriction almost any other type of fund raising costs can be partially allocated to program expenses.
What the Watchdogs Say
Because accounting rules are relatively lax, charitable watchdogs often recharacterize joint costs as fund raising expenses. The American Institute of Philanthropy (AIP) on its web site makes the following comments on how it rates the percentage of expenses allocated to fund raising costs:
"The mailings and phone calls of these (charitable) groups may serve a dual purpose: raising funds and educating donors. However many of these groups consider such mailings and phone calls to be largely educational and their costs to be primarily program expenses. In some cases AIP adjusts the higher number. For example, AIP may differ with a group's decision that the cost of acquiring new donors or members is a program service. Fund raising costs, i.e., direct mail and telemarketing, are often factored in as program expenses."
Not All Non Profits Fudge Joint Allocation Costs
While the accounting rules on joint costs allow for fudging on fund raising expenses, this should not be taken to mean that all non profits fudge these expenses. Certainly informative newsletters and bona fide calls to action combined with a fund raising appeal warrant allocations between program and fund raising expense. Unfortunately the rules also allow for abuse. And you cannot tell which organizations fudge and which do not just by looking at their Statements of Functional Expenses. To a certain extent watchdog groups such as the AIP can help because they look closely at the actual fund raising practices of many of the largest non profits. You can find their charitable ratings on their web site.
Other Tests of Whether Your Favorite Non Profit Spends Too Much on Fund Raising
As a donor you can catch on fairly quickly as to whether your favorite charity is spending too much on fund raising. Here are some indicators:
1.Do you have a 200 year supply of address labels provided by the charity?
2.Do you receive three times as many phone calls from your charity asking for funds as you do calls from your friends and relatives?
3.Does your charity request annual membership renewals two months after you paid your annual dues?
4.Has your charity sold your name and address to 100 other non profits so now you receive 4 times as many direct mail solicitations as personal mail?
5.Do you have to increase your anti-anxiety meds every time you receive a new "call to action" from your favorite advocacy group warning you that if you do not give them more money civilization as we know it will come to an end?
Big Unanswered Questions about Non Profit Efficiency
Even if all SFEs reflected an accurate and fair allocation of a non profit's expenses, there would still be big unanswered questions about efficiency. Efficiency is not just about minimizing administrative and fund raising expenses. Efficiency is ultimately about choosing the best strategy to accomplish the non profit's goals. Efficiency also involves hiring and managing competent staff and being accountable to an independent board of directors. It is entirely possible that an organization that spends 40% of its expenses on fund raising is, in this larger sense, more efficient than an organization that spends only 20% on fund raising. Unfortunately, these overall efficiencies or inefficiencies are utterly immeasurable by any financial statement. This is not to say that such overall efficiency is not measurable, but that any such measurements are not derivable from a non profit's financial statements.
April 30, 2020
Measuring Non Profit Efficiency: The Statement of Functional Expense
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