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How much is too much overhead?

The short answer: not too much but not too little. And what's "just right" will be different for different kinds of nonprofit activities.

One way to understand "overhead" is to remember the origin of the term. In manufacturing, expenses can be classified into three categories:

Materials
Labor
The factory building "overhead" in which manufacturing took place

The cost of the building is a shared cost -- a portion of the shared costs has to be recouped in the price of each item sold. For example, in a furniture factory, the price of a chair must cover the cost of the wood and the labor, but also a portion of the cost of the building, electricity, insurance, and so forth.

In nonprofits, overhead refers to costs that are shared by all the programs. For example, in a community center that has a senior meals program and a youth program let's say, there are two types of costs:

Direct costs: costs which clearly belong to one program or the other, such as meals for the senior programs, the salary of the senior activity director, and so forth.
Indirect costs, costs which are necessary to both programs, but which can't be easily divided between them, such as insurance, accounting, senior management time, Internet costs.

Too hot? Too cold?

So too much overhead isn't good business: if the furniture company spends too much on facility and insurance, it may need to buy cheaper materials or less-skilled workers to keep the price of the chair reasonable.

At the same time, if it spends too little on overhead, soon the roof will be leaking, and the electrical systems will be failing.

Just right?

The "just right" amount of overhead in one furniture factory will be different than in other factories. Imagine there are two factories, both making the same number of chairs and having the same amount of overhead costs. If one of them uses expensive woods and the other uses cheap woods, the first one will have a lower indirect cost rate (or percentage), but it will also have to charge a higher rate per chair.

In addition, a furniture factory will have more overhead than a janitorial company (which has lower equipment costs), but less than an car manufacturer (which has very high equipment costs).

So is a nonprofit more like a furniture factory or something else?

Just like the furniture factory (or any kind of company), a community nonprofit needs to have overhead, but it's possible to have too much or too little.

A nonprofit with unnecessarily high overhead costs may find it has to cut back on the quality of services. For example, a theatre that has an overly large and expensive performance space may not have enough to spend on quality sets, actors, and crew.

A nonprofit with overly low overhead will quickly find that it has a leaking roof, inadequate insurance, not enough money for marketing, and fewer funds to attract and retain qualified staff.

Overhead rates vary widely within the nonprofit community. For example, Harvard University has a 68% overhead rate for on-campus research, while Iowa State University has a 48% rate. Rand Corporation reports that airplane manufacturers have an average overhead rate of 35% while Trinity Marketing reports 55% as an average rate in advertising agencies.

Do nonprofits usually have too high or too low overhead?

Community nonprofits typically have overhead that is much too low. They often underspend on essential, basic costs such as rent and insurance. They can't afford adequate accounting staff, good technology, or human resources management. They often try to compensate for under-funding of programs and systems by having too few staff or paying staff poorly. The consequences of under-investing in overhead are financial weakness and inefficiencies at the nonprofit, and as a result, fewer services or lower quality services.

And so...

Nonprofits need to understand their overhead, and to make sure they stay between the goalposts: one marks too much overhead and the other too little overhead.

Perhaps more important than comparing an airplane company to an advertising agency -- or a childcare center to an wildlife conservation nonprofit -- is the call for attention to overhead. Executive staff, board and funders should understand overhead in a given nonprofit, and be satisified that it is -- like Goldilocks' porridge -- just right.