Published on August 15th, 2014 | by Kimberley Scharf0
Fixed costs and efficiency in the non-profit sector
Of late, there has much on how charities manage their finances and spend the money that they raise. The focus seems to be on the concept of fixed costs, and how donors perceive this; in fact, JustGiving.com did another interview with me on this topic which appeared on their blog recently (see How Donors Perceive Charities’ Fixed Costs).
Fixed costs and efficiency in the non-profit sector is the focus of my current research. My colleagues Ganna Pogrebna and Carlo Perroni and I are looking into why charities worry about fixed cost so much. And what we are discovering is that analysing performance of the non-profit sector requires different economic tools to the ones we use when analysing performance in the for-profit sector.
But first, what are fixed costs?
In economic terms, fixed costs are those that do not scale up with output. In accounting terms, they can be administrative or overhead costs, associated with IT systems, financial systems, skills training or even salaries in some situations.
Most people understand the implications of fixed costs and scale economies for private companies to achieve efficiency and in private markets, the most cost-effective technology will usually win. Firms that use fixed cost technologies can capture scale economies that allow them to offer their products at a cheaper price.
Similarly in the non-profit sector, even though charitable goods and services cannot be ‘bought’ and ‘sold’ as in private markets, charities need to be run efficiently. And in order to be cost-effective, charity providers must incur fixed costs as their scale of operation increases.
However, economists are mainly concerned about efficiency, and we find it very strange that this idea of cost effectiveness and fixed costs seem to present special challenges for charities, who seem to relate to fixed costs very differently than do private firms.
In fact, charities seem to worry about how fixed costs affect their position and viability. According to Rosemary McCarney, CEO of Plan Canada, there is a belief that a charity is good if it only spends 20% on administration and fundraising, and the remaining 80% on program costs. And if a charity spent out of that approximate range, they would be considered somehow bad or inefficient, she said.
In other words, there seems to be a perception in the non-profit sector that donors do not want to pay for fixed costs. In fact, Moneysense magazine, which grades Canada’s 100 biggest charities based on program spending efficiency, fundraising costs, governance and transparency and cash reserve, says it gives its best score to those charities that spend 85% or more on programs. It also considers charities that spend just 15% or less on overhead costs to be highly efficient!
This perception seems to imply that a ‘good’ charity has a small fraction of fixed costs relative to variable costs, and the view seems to be that fixed costs are considered wasteful while variable costs are interpreted as measuring actual program activities. This however makes no sense from an economics point of view. To economists, that’s like saying that research and development expenditures that result in innovations are wasteful!
Such a view has implications for efficiency within the non-profit sector. If charities face a situation where donors are reluctant to pay for fixed costs, then they may worry that donations will flow to relatively less efficient (low-fixed cost) charities. And if charities respond to these worries by adopting inefficient strategies that avoid fixed costs, this may lead to an innovation slowdown in the sector. Both of these scenarios lead to inefficiencies within the sector.
In our research so far, what we have found from preliminary lab experiments is that donors do seem to consider charities that incur relatively large fixed costs as being more ‘risky’, and so they are more likely to choose a less efficient lower fixed cost charity. This research provides evidence that perceptions and responses to perceptions can cause serious inefficiencies, some of which can manifest as innovation slowdown in the non-profit sector.
Direct evidence of the efficiency implications of such behavioural conjectures and responses not only means that there is a rationale for corrective government intervention that is systematically targeted to fixed costs, but that explaining what fixed costs are, why they are necessary, and especially what difference they can make for charitable programmes could go a long way to offsetting donors’ negative perceptions.