The myth that low overhead rates or administration costs are a useful indicator of nonprofit efficiency has proved remarkably persistent, despite studies showing that overheads vary significantly by type and size of the organization. This myth drives a starvation cycle of under-funding of core functions by funders, with negative consequences on organizational health and effectiveness.

Humentum’s recently published report, Breaking the Starvation Cycle, was one of the first studies to provide data on the adequacy of cost coverage provided to lower and middle-income country nonprofits. The research found that over 60 per cent of funding agreements fail to cover full administration costs incurred by grantees to deliver expected outcomes. The research was commissioned by Funders for Real Cost, Real Change (FRC), a collaborative of private foundations, and provided recommendations on how funders can provide adequate cost coverage and strengthen their grantees’ financial health and resilience.

The first key recommendation is that ‘funders must commit to consistently covering a full and fair share of all associated administration costs.’ Our research found that nonprofits subsidize inadequate cost coverage by donors with funding originally destined for other purposes. We also found that the funders providing the most inadequate cost coverage were frequently intermediary funders like the UN agencies, the European Commission and INGOs. Humentum postulates that the failure of the upstream donors funding these intermediaries to require the cascading of full cost coverage policies results in inadequate cost coverage of downstream grantees. It is also possible that some of these intermediary funders are themselves unable to recover their administration costs and thus pass along this disfunction to their partners.

The second key recommendation is for funders to ‘directly fund grantees to strengthen their financial management, cost recovery and fundraising capabilities, and provide unrestricted funding to build reserves.’ The first part of this recommendation stems from a somewhat unexpected research finding, that adequate cost coverage and access to some unrestricted income was necessary, but not sufficient to ensure grantee financial health. We believe the mission-driven nature of nonprofit work helps explain this finding as nonprofits tend to prioritize the quality of their programming over their own organizational health. Nonprofit leadership should be encouraged and emboldened to prioritise the resilience of their organisations and staff and to invest in the capabilities needed to achieve the sound financial strategies and cost recovery practices that lead to resilience. Nonprofit boards also have a role to play in ensuring the accountability of leadership to ensure organizational health. While this sort of resilience-forward governance is ultimately the responsibility of the organization itself, donors have a role to play in co-creating and funding appropriate support mechanisms that can assist organizational leadership to grow and institutionalize these capabilities. Humentum is working with funders and nonprofits to create a toolkit and learning platform to support these efforts to strengthen financial health and resilience.

The second part of this recommendation concerns the need for unrestricted funding to grow the reserves that provide the nonprofit with both a safety net and the investment funds needed to scale its efforts. Even if funders provide full cost coverage, many grantees still operate in a context that allows limited opportunity to generate unrestricted income and therefore unrestricted reserves. While many funders form long-term relationships with their grantees, their focus tends to be on increasing programmatic impact rather than organizational resilience. If programmatic growth is not accompanied by proportionate growth in unrestricted reserves, the nonprofit may become increasingly at risk to financial shocks and funding gaps, both of which will ultimately undermine their programmatic success. We recommend that funders provide a portion of project grants in the form of unrestricted support, as we know that even a small amount of unrestricted funding can lead to disproportionate improvements in the financial health of grantees while adding relatively little to the overall cost of project grant portfolios of funders.  

The third and final key recommendation is that ‘Funders should systematically collect data on the extent of adequate cost coverage.’ This final recommendation recognises the importance of funder accountability for the quality of both the programmatic and organizational health of their grantees. These data should be used to drive internal accountability at the organizational level while motivating funders to provide their full and fair share of administration costs in restricted funding agreements.

Conclusion

Funders have special responsibilities stemming from their role as a major source of financing in the social sector. Many funders are actively seeking to shift power and move toward more locally-led approaches and Humentum believes this will only be possible if we move to more equitable distribution of power around things like program design, staffing decisions and budgetary control. In our experience, power over these critical aspects of how nonprofits operate tends to be ‘sticky’ and hard for funders to genuinely transfer to their grantees. By implementing the report’s three key recommendations, we believe funders can truly ‘walk the talk’ and break the starvation cycle that has trapped both funders and nonprofits for far too long.

Join us for a panel discussion of the research and recommendations with Kathy Reich of the Ford Foundation, Aidan Eyakuze of Twaweza (the Case Study from a participating nonprofit in the report) and the research team on June 15, 2022.

Dr Christine Sow is the President and CEO of Humentum. Tim Boyes-Watson is the Global Director of Influence and Initiatives and led the research team.