Increasingly, donors are looking at the effectiveness of nonprofit organizations in turning donations and other resources into impact and mission fulfillment as a determining factor in making future donations. This article by Shalina Omar discusses a new study from researchers at North Carolina State University that challenges the “status quo of using financial ratios for measuring the efficiency of nonprofits.”
The author begins by stating the issue at hand: “How efficiently a nonprofit is able to turn resources into goods and services for their communities is an important concern for all stakeholders.” The current “favorite” is to use the overhead ratio – taking overhead expenses and dividing by total expenditures – meaning that organizations spending the least on overhead costs are ranked as the “most efficient.” The authors of the study believe the issue with this methodology is that it only takes into account monetary inputs without accounting for or even considering outputs (i.e., benefits produced for the community). As “efficiency” is commonly defined in terms of a ratio of inputs to outputs, this measure would seemingly fall short in measuring efficiency.
The researchers suggest two other methods for measuring efficiency: Data Envelopment Analysis (DEA) and Stochastic Frontier Analysis (SFA). We will avoid an in-depth discussion of these two methods here, but suffice it to say that both, while more complicated to calculate, are significantly more capable of considering inputs and outputs. As part of the study, the researchers analyzed nearly 800 affiliates of Habitat for Humanity. The study found, “when ranked by the overhead ratio, the top-ranking affiliate had a very low ratio of less than one percent, but it only produced two new houses. In contrast, the top-ranking affiliate according to SFA provided 382 houses. It ranked 43 for DEA, but because the overhead was 32% it ranked 676 according to the overhead ratio.”
Given the disparity of results and how efficiency rankings can play such an important role in gathering resources for nonprofit organizations, the article and researchers conclude by urging “nonprofit managers as well as donors and scholars to move away from using financial ratios to measure organizational efficiency.”
We believe benchmarking nonprofit performance is important, but agree with the author that outdated methods such as the overhead ratio can lead to sub-optimal management and performance.
We would highly recommend reading the article and underlying research study to see if these different efficiency calculations could benefit your organization in managing strategic decisions and in reaching donors.
- This article by Shalina Omar discusses a recent study that looks into measuring nonprofit efficiency.
- The article discusses how the status quo favorite, the overhead ratio, is ineffective, and suggests Data Envelopment Analysis and Stochastic Frontier Analysis as alternatives with more relevancy.