Analysis of the Relationship of Overhead Spending and Nonprofit Efficiency

Donors often use overhead ratio—the percentage of a non-profit's revenues that go toward general administrative and fundraising costs—to decide to whom and how much to give. However, because charity output is difficult to measure, the validity of using overhead as a heuristic to decide charity quality is difficult to identify and may induce inefficiently low levels of overhead spending. Guided by a simple model of non-profit production, we use IRS administrative data from 1984 to 2014 to measure the administrative efficiency by which non-profits transform overhead into revenues. The model suggests two kind of administrative efficiency to judge a non-profit, allocational efficiency, whether overhead is being spent at the point where marginal returns equals marginal costs, and technical efficiency, the efficiency that non-profits transform overhead into revenues. We adapt standard instruments to estimate these parameters from the literature for different quintiles of the universe of all charities. We find that non-profits systematically under-invest in overhead in terms of allocational efficiency. Services to the Poor, Hospitals, and Aid to the Handicap sectors are the sectors that most underspend on overheads. The model and pattern of underinvestment coupled with proprietary data from a popular charity evaluator suggests that reputational concerns may be responsible. To determine whether the overhead ratio is a good measure of productivity of a charity, we conduct a Levinsohn-Petric estimate of the total factor productivity of organizations and examine the relationship between productivity and overhead ratio. We find that there is a weak but significant relationship between overhead ratio and productivity, though the sign of that relationship varies by subsector