Why not to invest based on indirect cost ratio

Quanta Corporate Citizenship
File Size:	1173 kb
File Type:	pdf

Download File

---

A particularly important issue when it comes to measuring an organisation’s performance are the indirect costs, including overheads. Although many donors use indirect-direct cost ratios as a tool to assess their grantees’ performance (and some even pre-establish the maximum amount an organisation is allowed to use to cover its indirect costs), if not done carefully, donors might face two kinds of problems: manipulation and interpretation.

Manipulation

Different accounting principles can generate very different outcomes on how costs are allocated. A few years ago I worked with an organisation where its US operation had 17% overheads and its Norwegian operation had 4% overheads, but if the costs were allocated in the same way, the Norwegian operation would have had a higher overhead cost. Without clearly understanding the accounting mechanisms used by different organisations, simply looking at the percentage of indirect costs will not tell the donor how effective or efficient the recipient is.

By setting unrealistically low indirect costs, a donor might be providing incentives to the charities to manipulate their data or to become less efficient. A few years ago I was working with the merger of a few NGOs who would greatly benefit from co-locating their offices in West Africa and reducing the number of local head offices from 3 to 1. But one of the organisations was resistant to the idea because, although they could account for their stand-alone office as a program (direct) cost, if they paid their share of the new local head office via the merged organisation, that cost would need to be accounted as an indirect cost, going beyond what was an acceptable indirect cost ratio to their main donor. So even though their office rent cost would actually go down by close to two-thirds and both beneficiaries and donors would be incredibly better off, they remained opposed to the idea.

If indirect costs become a bottleneck, charities might be tempted to lower the proportion of indirect costs by increasing the value of in-kind donations to be distributed to the beneficiaries, or by changing the stock accounting system used, by accounting for volunteer time, cross-charging for things that were not cross-charged before, or any other clever way to make sure they are able to keep working. But playing with accounting is simply distracting and hinders serious historical and cross-sector analysis that would be much more useful to donors, charities and, ultimately, beneficiaries.

Recipients can use a myriad of different tactics to reduce their indirect costs, from implementing and manipulating timesheets to activity-based costing (ABC). Before jumping onto the indirect cost bandwagon, any donor keen to use it should (a) have a clear definition of what it will define as indirect costs, (b) what is a desirable level of indirect costs for different kinds of operations in different scales and in different places, and (c) make sure that it is worth its (and the charities’) time to realign the financial statements and analyse them according to its own definition of indirect costs. Although the first one is relatively easy, the last two are much easier said than done, and generally prove themselves to work against the donor’s own interest, if the amount to be donated is relatively low.

Donors often forget how cash-starved charities really are. Very few charities will ever turn away potential funds, and the majority will try to jump any hurdle potential donors present to them. They believe so strongly in their cause that they think that almost any burden is justifiable if it helps them to get close to delivering against their social need. By setting too many benchmarks that are too complex or too restrictive, donors might be sending mixed signals to the recipients and might unintentionally be misaligning their objectives and incentives. The first rule of transparency is to keep things simple. The second is to keep them meaningful.

Interpretation

Even if two organisations have identical accounting policies and cost allocation processes, the one with higher overhead cost might be delivering better results to beneficiaries and donors than the one with lower indirect costs. Moreover, excessively cheap programmes might not be sustainable. If organisations are constrained by very low indirect costs they might focus on lower-impact projects and lower-need areas that require lower indirect costs. They might also compromise their long-term survival or ability to innovate (for instance, by cutting high-calibre staff and aborting programmes still on their inception phases). By focusing on indirect cost reduction, they might increase the long-term dependency on the donor (for instance, by reducing the diversity of its funding portfolio or reducing its ability to fundraise) and might compromise investments on systems and training that are able to indicate its actual performance or could leverage existing or future performance. This could mean an organisation stops implementing or upgrading IT platforms or eliminates auditing functions, or reduces their monitoring and evaluation efforts, or precludes knowledge sharing internally and externally.

Worse: they might not be delivering what is expected and desired by their beneficiaries. In the same way that no one would buy a Ferrari for one thousand dollars, any donor should be careful when partnering with an organisation with excessively low indirect costs.

Donors should only partner with those they trust. If they do not trust that the receiving organisation will be using its money adequately, or will not be efficient in using it, it should not partner with it in the first place. A marriage started on the presumption of mistrust bears no reasonable chance of success.

Clearly, as in any other walk of life, the giving organisation should try to align the receiving organisations’ incentives to its own. Although it is always desirable to keep the indirect costs to a minimum, different kinds of programmes, different kinds of organisations, and different locations require significantly different cost structures. If donors want to avoid NGOs overspending on indirect costs, they first need to understand the NGOs’ cost structures and have a good understanding of what a “good” project would look like.

More important than specific indirect cost targets are the existence of transparent financial statements, of reliable audit reviews, and good monitoring and evaluation that allows both parties to assess the current performance and know what needs to be improved. But even these essential elements only make sense if the donor understands its own reasons for partnering with an NGO and what the NGO is actually trying to achieve and how. Without answering these questions first, financial statements and audit trails are great tools without a clear purpose.