Administrative Expense Ratios: Informative or Misleading?

All nonprofits need administrative staff to support the mission of the organization. Someone has to process the payroll, keep the computer network running and tend to the seemingly endless number of tasks that enable the program personnel to keep their focus on the mission. Even small nonprofits with only a few employees have someone who is managing how that work gets accomplished. (Through outsourcing, volunteers, etc.) Administrative expense ratios highlight the percent of revenue that is spend on the administrative functions.

These expenses are commonly referred to as Management and General (M&G) and are allocated to the program(s). To calculate the administrative expense ratio, one simply divides M&G expense into revenue. This ratio is frequently held up as a tool that can be used to measure efficiency between organizations.

Well, you ask, what's the problem with all of this? If Social Service Agency A has a ratio of 12%, while Community Theater B has a ratio of 19%, the leaders of the community theater must not be running their organization as well. Right?

I contend that the information presented above doesn't give near enough information to make such an assertion, but too often that is exactly what is inferred from such data.

Here are the two major problems with relying solely upon an organization's administrative expense ratio when evaluating efficiency.

• The size and type of an organization aren't taken into consideration. Cost structures vary between types of nonprofits. In our example above, perhaps the average community theater has a ratio of 20% while social services average 10%. Does that change anything? Larger nonprofits should also be able to achieve economies of scale and reduce costs in areas where smaller nonprofits might not.
• Not all nonprofits record M&G expense the same. Although some variation can be attributed to differences in the knowledge of finance staff or how reporting guidelines are interpreted, the possibility of organizations 'managing' that ratio also exists. Managing the administrative expense ratio to coincide with donor expectations is no different or less harmful than when public companies were managing earnings to expectations from Wall Street.

This is not to say that administrative expense ratios are worthless. One manner in which they are useful is in monitoring how an organization's ratio changes over time. This can provide an insight into the direction of the organization if used in combination with other data. No matter your connection to the nonprofit world, be aware of this ratio, but also be aware of its limitations.

Introduction

Over the coming months, I plan to use this blog to share my thoughts on topics that relate to nonprofit finance. Not every post will talk debits and credits though, and my hope is that nonprofit staff of all disciplines find it beneficial to follow along.