Breaking the Starvation Cycle with True Cost Funding

Most funders support nonprofits with grants earmarked specifically for direct program expenses. On the face of it, that sounds pretty sensible. After all, if you want to make sure each dollar is put to the best possible use, it stands to reason that program work would be the first priority.

But when the majority of funders limit giving to direct program costs, nonprofits are left holding a pretty significant bill for the indirect costs that are a necessary and perennial part of their operations. They are forced to scramble to find the resources needed to cover their overhead costs. Often, they must make do on a shoestring budget that doesn’t sufficiently address their needs. It’s a starvation cycle that only serves to undermine organizations and impair impact.

Today, more and more nonprofits (and even a few funders) are pushing for a “true cost” or unrestricted funding model. True cost funding gives organizations the freedom to support themselves appropriately — and become more effective and independent in the process.

The Starvation Cycle and the Problem with Program-Based Funding

At root, restricted funding stems from a lack of trust in nonprofit organizations. Whether the concern is inefficiency, mismanagement, or even fraud, the result is the same. Program costs are deemed virtuous, while overhead expenses are all but stigmatized. Unfortunately, rather than making nonprofits and their programs more efficient and effective, this line of thinking shoots them in the foot. That’s because even the leanest, most streamlined social impact organization has overhead costs. Those costs are a necessary part of the package. And they aren’t going anywhere.

To put the perpetual underfunding in perspective, consider this: Major foundations traditionally put a 15 percent cap on overhead reimbursement. Yet a recent study of twenty nonprofits found that indirect costs make up between 21 and 89 percent of direct program costs. Even the organizations with the lowest overhead costs had expenses totaling more than 15 percent of direct costs. And the median rate found in the study — 40 percent — is nearly three times the typical 15 percent cap.

The study also found that different types of nonprofits have different overhead costs. For example, research laboratories were found to have consistently higher overhead costs than direct services agencies (primarily because of the high cost of research equipment). Among for-profit businesses, this sort of industry-by-industry variation is expected and understood. But the same can’t be said for segments in the nonprofit sector. The takeaway? One size doesn’t fit all. A flat-rate overhead reimbursement of any amount doesn’t make sense.

The current funding practices mean that nonprofit organizations are almost always running their operations on a serious deficit. With the ever-present specter of empty coffers, nonprofits operate in starvation cycles and with a scarcity mindset. They are unable to compete for the best talent, retain staff, build capacity, and ultimately achieve the impact they aim to create.

For many nonprofits, true cost funding is a critical component to breaking the starvation cycle.

True Cost Funding: Holistic Budgets for Increased Impact

As you might expect, true cost funding is funding that covers the actual costs associated with an organization’s work. All of them. In addition to program work, true cost funding covers salaries and wages, rent, capital equipment and technology, marketing and communications, training, fundraising, and so forth. In that sense, true cost funding is holistic in nature. It understands that overhead expenses and program costs are inextricably linked.

When organizations receive true cost funding, they are freed up to:

• Focus more intently on running their programs. Underfunded organizations are constantly on the hunt for additional funding. This pressure to make ends meet saps organizations of energy and focus. As staff are forced to spend more and more time applying for grants, program work gets put on the back burner. Conversely, when organizations are free to use grant money to cover their overhead costs, they can focus more keenly on what matters most: working toward creating impact and fulfilling their mission.
• Be more transparent with funders about the real cost of achieving impact. Many social impact organizations implicitly understand that they must present funder-friendly budgets that show low overhead costs. However, the pressure to appear ultra-streamlined can lead organizations to be less than transparent about the true cost of making an impact. This serves to further the starvation cycle. And it also obscures the true cost of making an impact.
• Pay living wages that attract and retain the best talent. Nonprofit organizations have never been able to compete with corporate salaries. But many nonprofits are unable to pay even living wages to their employees. The result? High rates of burnout and turnover. And hidden costs in the form of frequent hiring.
• Support their core work at a structural level. True cost funding enables nonprofits to invest in tools, training, and technology that support their core work at a structural rather than programmatic level.
• Pursue innovation. Innovation is key to finding new solutions to the world’s biggest problems. But innovation isn’t free, and it’s usually not built into a nonprofit’s ongoing program costs.
• Invest in marketing and communications. It’s questionable whether marketing and communications should even be lumped together with overhead (which is defined as ongoing operational expenses that aren’t associated with creating impact). That’s because marketing and communications are directly tied to impact. When organizations have the resources necessary to invest in their own branding, marketing, and communications, they do a better job of raising awareness, raising funds, and inspiring people to get involved.

How to Embrace True Cost Funding

Unrestricted funding models are built on trust. If you’ve always relied on restricted funding, start small. Find and vet a values-aligned, effective nonprofit and provide a general operating grant. If you require reporting, work with your nonprofit partner to identify the most valuable metrics to focus on and jettison the rest. Then watch and see what happens.

We’re willing to bet that the results will be encouraging.