Paying what it takes to create impact
Today’s post from Sam Thorp and Dr. Jeremiah Brown (@jeremiahtbrown) is a summary of a new report from Social Ventures Australia (SVA) and the Centre for Social Impact (CSI), which finds that not-for-profit organisations across Australia are, in general, not funded for the actual cost of what they do. The result is less effective operations and reduced impact.
This article is a short-form version of an article published in the SVA Quarterly
Financial vulnerability is a significant and ongoing issue for the Australian not-for-profit (NFP) sector with a variety of causes and effects on the sector. In a new report we explored one critical aspect of this financial vulnerability, the NFP ‘Starvation Cycle’ in philanthropic* funding of Australian NFPs. The Starvation Cycle has previously been identified in the US and researched there, but has yet to be studied in the Australian context.
The Starvation Cycle
The Starvation Cycle is a cycle where (for a variety of reasons) NFPs experience systematic underfunding of their indirect costs over the long term. This leads to a range of issues linked to NFP effectiveness and financial vulnerability, and it can undermine their capacity to fully achieve their aims.
To deliver impact, an NFP must employ people, support them, and have the necessary infrastructure for them to work effectively. These costs have historically been separated out into ‘direct’ costs and ‘indirect’ costs based on whether they can be assigned to a particular project, even though they are all essential to creating impact. Indeed, indirect costs (or overheads) have become a fraught topic in the not-for-profit world. Some funders, donors, and even NFP staff view them as wasteful or unnecessary. Yet they are essential to running an effective organisation, and organisations that spend more on indirect costs are often more efficient, rather than less.
The Extent of the Problem
By one measure, Australian businesses spend twice the amount that NFPs do per employee on key capabilities such as training, information technology (IT), quality, and marketing. This leaves NFPs both less efficient and more vulnerable to external shocks. Funding the full cost of program delivery would allow NFPs to train their staff more effectively, have more efficient IT infrastructure, and report more accurately on their impact.
In the report we estimate the extent to which NFPs are underpaid for their indirect costs in Australia. Nine Australian NFPs, which ranged in size from $100m to $100k in revenue and worked across the arts, disability, and family services sectors, agreed to open their books for analysis. These NFPs had average indirect costs of 33% of their total expenses, with a range from 26% to 47% (see Figure 1). This far exceeded what is normally included in funding agreements (which generally range between 0% and 20%). This figure is also higher than what NFPs regarded as the maximum that philanthropy is willing to pay.
Figure 1. Surveyed NFPs had average indirect costs of 33%
‘Pay what it takes’ is a perennial issue
To ‘pay what it takes’ is to fund the full cost of running a project, including a share of the indirect costs that are needed to support it. However, indirect costs have an image problem and this means that funders (including the general public) will sometimes choose not to fund NFPs which have ‘high’ indirect costs. According to Genevieve Timmons, Senior Associate with the Alliances Portfolio at the Paul Ramsay Foundation, foundations find it a complex subject:
“In my early work with foundations and philanthropic donors, people talked about admin costs as if they were an unnecessary impost, and not relevant to charitable activities. This view has run counter to their priorities and experience as high level business people, where investment in staff, infrastructure and research is recognised as essential to success.”
This attitude towards indirect costs is common despite significant evidence showing that indirect costs do not indicate the efficiency or effectiveness of an NFP. In fact, the opposite is often true. Spending insufficient resources on indirect costs has been shown to reduce overall NFP effectiveness. This is intuitive – an organisation that can invest in training its staff, building good financial systems, and measuring its impact is much better placed to be effective than one that cannot.
The underfunding of indirect costs is not a new issue. As Jack Heath, CEO of Philanthropy Australia, says, funding difficulties have been a constant through his career:
“In my 20 years of leading not-for-profit organisations, getting the true costs of delivering programs and services paid for has been a perennial problem.”
Even where funders are willing to pay the full costs of programs, NFPs regularly under-report their indirect costs. There are many reasons that NFPs find it difficult to be honest about their indirect costs. The power imbalance between funder and fundee can make it difficult for NFPs to have honest conversations about costs with their benefactors. The competitive nature of the funding environment means that NFPs are discouraged from revealing information they believe could be potentially damaging to their grant opportunities, even if it may lead to better funding arrangements. There are also significant reputational concerns about indirect costs, with media commentary often being highly negative.
The funding of direct costs without indirect costs leads to what Jack Heath calls the “volcano funding approach”, where program delivery is funded but core costs are not:
“It leads to organisations where the centre is hollowed out, but it’s built up around the edges. And, you know, volcanoes do two things: they blow up, or they go dormant.”
Perverse incentives
NFPs have been battling with this issue for so many years that it has become ingrained in their processes. This includes many NFPs creating deliberate inefficiencies to reduce the ‘observed’ indirect costs of a project. For example, having frontline staff take on administrative duties as a component of their role, since their wages are easier to incorporate into a budget as a direct project cost.
But as noted above one of the strongest effects is long-term underinvestment in the areas covered by indirect costs. This not only decreases effectiveness, it increases risk as well – complying with regulations and funder requirements is, after all, an indirect cost.
What can be done
According to interviews with philanthropic sector leaders, philanthropic practice in Australia has started to shift towards paying for the full costs of creating impact.
Indeed, there is not only one way to pay what it takes. There are a variety of ways to fund the full costs of organisations, including providing full-cost project funding, untied funding, or capacity-building funding. Which of these models is best depends on the goals of the funder and the sector/issues they focus on. By having honest conversations with NFPs, funders get a better sense of how they can best support the NFP’s work and create the most impact.
Even where funders are open to paying for indirect costs, they still need to ensure they proactively understand their fundees’ true costs and demonstrate willingness to pay what it takes. Otherwise, as mentioned above, it is likely that NFPs will continue to deliberately under-report their indirect costs.
Part of this issue is a lack of good data. Funders are often unsure of the true costs of creating specific outcomes. NFPs can have a limited understanding of their own actual costs and how they should be allocated by project. A better understanding of cost allocation methods and better data on the cost of achieving outcomes will help to shift the power differential.
The public narrative about indirect costs also needs to change. The beliefs of the media and general public play a role here, often creating a situation where many people new to philanthropy or the NFP sector have a dim view of indirect costs that needs to be consciously reversed.
What you can do
Philanthropic funders are invited to join a community of practice around paying what it takes, led by Philanthropy Australia. The purpose of the group is to share best practice and help philanthropic organisations to maximise their impact.
Non-profit staff and executives are invited to join workshops later in 2022 on how to define and budget for indirect costs, and the best ways to ‘make the ask’ for full-cost funding.
To register your interest in either of these groups or to read the full report, “Indirect costs in the Australian for-purpose sector – Paying what it takes for Australian for-purpose organisations to create long-term impact”, see this page: https://www.philanthropy.org.au/tools-resources/paying-what-it-takes
This work was supported by the Paul Ramsay Foundation and Origin Energy Foundation.
*While government is the primary funder in the not-for-profit sector, philanthropic funders make significant contributions to this sector and many have already begun moving towards full-cost funding. They have started to solve the funding issue by creating trusted relationships and offering full-cost funding or untied grants, yet more must be done on both sides to create a sustainable and effective NFP sector.
About the authors: Sam Thorp is a Manager in the Consulting team at Social Ventures Australia. He can be contacted at sthorp@socialventures.com.au
Dr. Jeremiah Brown is a Lecturer in Public Policy with the Public Service Research Group in the UNSW Canberra Business School. You can find him on Twitter at @jeremiahtbrown.