Foundations often lack clarity on how indirect costs contribute to the overall health of the nonprofits they fund. While they carefully scrutinize the costs associated with programs, many foundations view indirect costs as a tax on top of their program grants. This couldn’t be further from the truth. 

For nonprofits, indirect costs include expenses critical to the efficiency and efficacy of grant-funded programs. Indirect costs are far more than traditional overhead. They consist of essential functions — like recruitment, technology infrastructure, and training — that ultimately affect the organization’s ability to execute its programming. 

Complicating matters, nonprofits operate without a broadly agreed-upon list of indirect costs, meaning that they define which costs are direct and indirect based on their business structure, programs, and other factors. Because of this, organizations count costs differently even if they provide similar services and are of similar size. This ambiguity makes it difficult for donors to compare organizations’ indirect costs, leading to a “lower is better” perspective.

Not surprisingly, foundations have reacted to this confusion by adopting various approaches to funding indirect costs. Many foundations have a flat-rate indirect-cost policy of, say, 15 percent of direct costs. Others leave it up to program officers to determine an indirect-cost rate, despite the fact that many lack an understanding of grantees’ operational costs and overall financial health. As a result, nonprofits face chronic underfunding of indirect costs, often characterized as the “starvation cycle.” Without adequate indirect-cost funding, nonprofits struggle to support the very programs that attract foundation grants.

How can foundations and nonprofits bridge this funding gap? A better understanding of indirect costs is a good place to start.

Assessing the Feasibility of Third-Party Indirect-Cost Verification

To that end, five foundations (Ford, Hewlett, MacArthur, Packard, and the Open Society Foundations) and The Bridgespan Group recruited 22 grantees to work with our firms, BDO and FMA, in a pilot program to verify their true indirect costs. The pilot required us to establish indirect-cost definitions and principles, as well as develop analytic tools to provide verification of the nonprofits’ true costs. Here’s what we learned from our work:

• Foundations have a significant interest in covering an adequate portion of grantees’ indirect costs, but they lack information on how grantees allocate costs and how specific indirect costs are essential to long-term sustainability.
• Many grantees experienced a “light-bulb moment” during the verification process. Generally, they had higher true indirect-cost rates than those reflected in their publicly available data. Perhaps more importantly, they had higher rates than typically covered by funders. Takeaways cited by grantees included a better understanding of cost-allocation concepts, the connections between cost accounting and financial statements, and the importance of planning and forecasting to fully cover indirect costs.
• For all the emphasis on determining an appropriate indirect-cost rate, it is equally important to ensure that the cost categorizations on which any rate is based are clear, consistent, and appropriate.
• There are significant variations in indirect costs among different nonprofit subsectors, but these differences are often not accounted for in foundations’ cost policies.

What Can Foundations and Nonprofits Do About Indirect Costs?

The pilot established the potential for a framework to classify indirect costs, a big step toward a solution to chronic underfunding. While sectorwide benchmarks may be the optimum answer to this problem, forging a consensus around standards will take time. Meanwhile, foundations and nonprofits can take several immediate steps to address grantee underfunding: 

• Understand Indirect Costs: Before a foundation can determine an appropriate indirect-cost rate for a grant, it needs to understand what costs an organization considers indirect and why they are critical for success. That means grantees must be forthcoming about how they distinguish between indirect and direct costs.
• Know That Low Indirect Costs Don’t Equal With Efficiency: BDO’s Nonprofit Standards survey found that, on average, 77 percent of nonprofits’ total expenditures go to support programs and services. While on paper that might look appealing, the reality is that without adequately investing in key infrastructure and operations, organizations could be setting themselves up for failure.
• Don’t Draw a Line in the Sand: Most donors see a grantee’s indirect-cost rate as merely a line item on a grant proposal. Too often, nonprofits go along with the indirect-cost rate suggested by foundations with little to no pushback. Grantees, however, should provide donors with details for indirect costs and work with the program officers to get the funding needed to support operational needs. For their part, funders should be open to feedback. 
• Talk to Peers: Foundations are uniquely positioned to come together to address the issue of indirect costs, acting as the catalyst for a sectorwide discussion that ultimately can help end the stigma around these critical expenses. Likewise, nonprofits should talk with peer organizations about their indirect-cost-allocation practices.
• Keep a Nonprofit Heart and a Business Mind-set: It’s critical for nonprofits and funders to keep sustainability at the forefront of their efforts. The world needs nonprofits to continue pushing for positive change, and for that to happen, they need to stay financially healthy.

A Movement Toward Standardization

A standardized approach to calculating indirect costs would help foundations understand and cover the appropriate amount of these expenses, ensuring the financial health and sustainability of grantees. The movement toward standardization is a marathon, not a sprint. To train for success in this race, the sector needs to develop a principles-based approach to identify what constitutes direct versus indirect costs. With that knowledge, foundations can avoid putting short-term impact over long-term viability. This will result in a sector that better meets the needs of both grantees and funders — and those they serve.

Andrea Wilson is a partner at BDO, where she leads the Nonprofit & Education Advisory Services practice. Hilda Polanco is the founder and CEO of FMA.