Guidestar says, “Nonprofits: Ban these phrases from your vocabulary. ‘Only X% of your gift goes to overhead costs.'”

BBB Wise Giving Alliance says, “We want to verify that the money a charity spends is being used to fulfill its mission.”

Charity Navigator says, “Charities fail givers’ expectations when their spending on programs is insufficient.”

And at their shared Overhead Myth website, they all say, “[Help us end] the false conception that financial ratios are a proxy for overall nonprofit performance.”

But on Halloween, the journal Science dropped this on us: “…informing potential donors that overhead costs are covered by an initial donation significantly increases the donation rate…”

TL;DR: Researchers at UCSD conducted a study to test whether shifting overhead expense to a third party affected donations. Turns out, it does. A lot. All while partially masking inefficiency effects.

Efficiency doesn’t matter, except when it does.

In that article, Uri Gneezy, Elizabeth A. Keenan, and Ayelet Gneezy ran a direct mail experiment to test whether framing a lead gift differently resulted in increased donations. There were a total of 40,000 letters mailed — 10,000 each of four different types:

  1. A control condition with no mention of other gifts
  2. Included text explaining that a donor had made a seed gift
  3. Included text explaining that a donor will provide a matching gift
  4. Included text explaining that a donor was covering the organization’s overhead for acquiring these gifts

The amounts of the seed, match and no-overhead gifts were identical.

The results:

  1. Response rate for the control condition: 3.36%
  2. Response rate for the seed condition: 4.75%
  3. Response rate for the match condition: 4.41%
  4. Response rate for the no-overhead condition: 8.55%

The direct marketers among you are probably salivating right now.

The researchers also make some interesting observations based on the results of a similar lab study. In that study, researchers found that a charity with no overhead was only slightly more likely to receive a donation over a charity with 50% overheadif that overhead was being paid by a third party.

In other words, donors don’t really care that much about efficiency. Instead, they care about the effect of their personal contribution.

But wait. How can all of these things be simultaneously true?

All restrictions are created equal

Perhaps you remember the fairly recent kerfuffle about Smile Train. Back in 2009, the American Institute of Philanthropy called out the cleft palate charity for its advertising that, “100% of your donation goes toward programs — 0% goes toward overhead.”1 This was apparently accomplished by two large initial gifts designated for overhead only. AIP wasn’t completely convinced though, and subsequent claims in Smile Train solicitations suggest that they don’t really care what AIP thinks.

But why was AIP on Smile Train’s case in the first place?2  Is there something inherently wrong with using some donations to cover overhead, allowing other donations to be restricted completely to programs?

Nope. We do this all the time. Any donor can walk in and say, “I want this donation restricted only to program costs,” and it’s up to individual charities to determine whether they want to accept the terms of that gift.

 So why does it feel shady?

Advertising that overhead costs are covered somewhere else does feel shady, especially when you see that it can be used to mask some of the the negative effects of an inefficient operation.

But there are two other big forces at work here, which we’ll tackle in part two:

  1. Agency theory and information asymmetry
  2. Fixed costs vs. marginal costs
 To be continued…

1. Note that this is different from saying, “we spend $0 on overhead costs,” which is impossible for a functioning organization. Active nonprofits reporting $0 in either of the two overhead categories on the functional expense statement portion of the Form 990 are either playing complicated games, or are reporting incorrectly.

2. AIP was on Smile Train’s case because their audited financials strongly suggest that the decision to use those two gifts to cover overhead was retconned. A less sinister explanation might be really sloppy nonprofit accounting.