Administrative Costs Can Be the Worst Way to Judge a Charity

Administrative Costs can be the worst way to judge a charity

Though low administrative costs could indicate prudence and sound judgment at a charity, it could just as easily indicate inadequate staffing, insufficient salaries or, shall we say, fudging.

Donating to charity is a worthy action. But which charity? Would it surprise you to know that the criterion that is most often used to decide that question is also the most unreliable? Would it surprise you more to know that many charities are aware of how flawed the criterion is and play it like a violin?

A few months ago a friend of mine who runs an international relief agency phoned me complaining about another charity.

"Do you know what they're doing?" he fumed. "They're buying medicine in Canada for 10 cents a pill and booking the American retail cost of the medicine as an in-kind contribution. Do you know the retail value? Seven bucks a pill. They're padding their in-kind contributions by millions of dollars."

I hung up a little perplexed at first. It wasn't like the organization was buying pills for a dime and selling them for $7; it was were giving them away. Outside of inflating their donations for bragging rights, I couldn't see the harm. Then it hit me.

I went to the organization's website and there it was, one click off the home page: Nearly 90% of its donations in 2011 went directly to the group's programs. Its administrative costs? Just 5% of the budget. But if the agency was inflating in-kind contributions, it could hike the value of its donations to make its administrative costs seem smaller.

Why would it do that? Because low administrative costs are the holy grail in judging how well a nonprofit does its work. It's not the only thing responsible raters look at, but it's the shorthand. The best of the best in one Top 20 list last year, for example, was a charity that spent nothing, nada — 0.0%, as the list put it — on administration. Too bad that, as a measure of value, low administrative costs are unscientific and meaningless.

Don't get me wrong. Low administrative costs could indicate prudence and sound judgment at a charity, but they could just as easily indicate inadequate staffing, insufficient salaries or, shall we say, fudging. Moreover, administrative costs aren't the primary measurement of for-profit excellence. Are McDonald's admin costs lower than Wendy's? Apple's lower than Microsoft's?

Why then do we continue to buy such a boneheaded yardstick to measure nonprofit organizations?

Daniel Kahneman, the Nobel Prize-winning economist, in his brilliant new book "Thinking Fast and Slow," calls it substitution. Each of us, Kahneman writes, has in effect two systems of thinking — an intuitive system that we rely on for quick answers, hunches and gut reactions, and a rational, statistics-driven intellectual system. As superior as the rational system may seem, it has a flaw: It's lazy, and it will defer to the intuitive system whenever it can, especially if the intuitive answer comes cloaked in seemingly scientific justification.

On top of that, our intuitive thinking system also hates hard work, Kahneman says, and if figuring out the answer to a problem is too difficult or complex, we often simply substitute a different, easier answer for the hard work, and we may not even be aware we are doing so.

It is really hard to judge the merits of most nonprofit organizations programmatically. Are people smarter, healthier, do they drive better, get fewer divorces or smoke less as a direct result of a nonprofit organization's intervention? These are the questions we should be asking, and there are many who are trying to do just that every day, internally in nonprofits and in universities and research centers across the country.

But our intuitive thinking system wants an answer now, and because we are intuitively inclined to believe that the nonprofit sector is filled with soft, amateurish executives, we latch on to the pseudo-science of administrative costs as a measure of excellence. It's hogwash; there is absolutely no way of telling that an organization with 5% administrative costs is superior to one with 20% costs based on that criterion alone. In fact, the exact opposite may be true.

Using administrative overhead as a mark of excellence will be a hard habit to break, however. According to the National Center for Charitable Statistics: "For better or worse, the percentage of total expenses going to program costs is the most common measure of nonprofit organizational efficiency. Focus group research has found that donors expect worthy organizations to have low fundraising and administrative costs. Consequently, nonprofits frequently tout their low overhead ratios in their mailings to the donors." Or on their websites.

There are a lot of great reasons to donate to a charity — competent staff, involved and committed board and volunteers, a well-defined and engaged constituency, and a track record of past success. When you find the right nonprofit, honor it with your time and treasure. But let's bury the substitute easy answer of administrative costs. That's no way to choose a charity.

Jack Shakely, President emeritus of the California Community Foundation 

April 30,2012