Overhead.  It’s a loaded word in Nonprofit Land. And scary because so many people talk about it with confidence when they clearly have no idea what they are saying. You hate to correct them because you are a little unsure about it yourself.

You know overhead is essential. How can you set the record straight? And gain confidence that you have a handle on your own organization’s overhead? In this and future posts, we will seek to demystify the subject of nonprofit overhead.

Confusing Terminology

As if the term “overhead” was not confusing enough, consider all the terms that can mean more or less the same thing:

• Administrative costs
• Management and general expenses
• Supporting services
• Fundraising expenses
• Indirect costs
• Infrastructure costs

It’s enough to make your head spin.

In the end, it all boils down to expenses that are one of two things:

1. Program Expenses
2. NOT Program Expenses

In this light, it’s easier to get started on a plain English discussion of overhead. We will talk about program vs. nonprogram expenses, why you should care about making a distinction, and how to keep track of these expenses in your accounting system.

Three Reasons to Care about Program vs. Non Program Expenses

We can give you three big reasons why you should care about being able to distinguish program expenses from nonprogram expenses:

1. It’s required by Form 990 and Generally Accepted Accounting Principles (GAAP).
2. It’s expected by donors.
3. It will help you negotiate more funding.

We did not misspeak on that last point – understanding program vs. nonprogram expenses will help you negotiate more funding. If you are stuck with a paradigm of chopping up nonprofit expenses into expenses for programs vs. expenses NOT for programs, you may as well make the most of it! More on this below after we give you a little background on the first two reasons.

Expenses in Form 990 and Audited Financial Statements

Form 990, the annual information return for nonprofits required by the IRS, requires presentation of expenses by three areas:

1. Program services
2. Management and general
3. Fundraising

These expenses are reported in Part IX of Form 990, Statement of Functional Expenses. Reporting expenses in this manner is referred to as reporting expenses by functional area. (If you file Form 990-EZ you must report expenses for programs. By default the difference between program expenses and total expenses is nonprogram expenses. If you file Form 990-N, you don’t have to report any financial amounts, however you may still have to report expenses by functional area to the state where your organization is domiciled.)

You are also required to report expenses by functional area in audited financial statements prepared according to Generally Accepted Accounting Principles (GAAP). Expenses must be broken out by the same three areas as required by Form 990. You may see nonprogram expenses grouped together on the Statement of Activities under the heading “Supporting Services,” which is a more graceful way of saying “NOT Program Services.”

As a result of Form 990 and GAAP reporting requirements, thinking in terms of program vs. nonprogram expenses is baked into our society’s view of nonprofits. Further entrenching this manner of thinking are the nonprofit watchdog groups such as Charity Navigator, CharityWatch and the Better Business Bureau’s Wise Giving Alliance, which rely heavily on nonprogram expenses as disclosed in publicly available Form 990s in determining their ratings of a charity’s worthiness.

No way around it – if you manage a nonprofit organization, you need to understand what expenses are for programs and what expenses are NOT for programs.

More Funding in Grants and Contracts

Often we see contracts drawn up for nonprofit services that only cover the direct costs of programs. Similarly, we see restricted grants or gifts that only cover “program” expenses. Programs require an organization in which to operate.  Programs cannot function without organization infrastructure – information technology, human resources, accounting, general management, insurance, rent, utilities – the list goes on. Some of these expenses are considered purely “NOT program” in nature, others can be allocated in part to program and in part to supporting services.

To take on program funding that does not provide for the organization infrastructure is to participate in the same myth that funders fall prey to – that somehow all these wonderful programs can be provided out of thin air by good-natured volunteers who presumably work out of their cars or homes and provide all their own computer equipment. These folks are indeed miraculous – they need no management, no paycheck, no training and no coordinated way of communicating other than their personal cell phones. And all the accountants for the organization work for free.

Of course we know this idea is silly.

Therefore, be sure to negotiate a rate for organization infrastructure costs in any restricted gift or contract. The Federal government uses the term “indirect costs” for costs that “cannot be readily identified” with the primary grant purpose, but that are essential to carrying out grant-funded programs. The Feds now pay a default indirect cost rate of 10% of “modified total direct costs,” (roughly translates to 10% of total expenses) on Federal grants, but nonprofits can apply for a higher rate since 10% is pretty much rock bottom. The Federal government understands that nonprofits must cover costs in addition to program costs, and that these costs are essential to the organization’s existence and, hence, to the existence of programs. What a refreshing concept.

We realize this post raises new questions on just exactly how small nonprofits are supposed to go about determining and tracking program expenses vs. nonprogram expenses. Also you may be wondering what is a “cost” vs. an “expense.” We have answers – which we’ll get to in our next post. In the meantime, we welcome you to share your comments, questions and experiences dealing with “overhead.”