Saturday, December 29, 2012

Improving Measures of Efficiency

For some time now, the primary measure of charitable efficiency has been the accounting-based program expense ratio, which measures the percentage of expenses that are classified as program related (as opposed to those related to administration or fundraising).  The heavy reliance on program expense ratios by watchdogs, donors, and the organizations themselves, often to the point of ignoring the remainder of an organization’s financial statements, cannot be denied.

That said, recent years have seen a backlash against the prevalence of these accounting-based measures.
Critics note that program expense ratios only reflect where money goes and do not reflect the impact of the funds put to use; plus, it has been argued that fundraising and administration are vital parts of an organization, and forcing charities to minimize them can be counter to an organization’s broader objectives.  To make matters worse, both (i) the liberal use of cost allocation rules to allocate more joint costs toward programs, and (ii) the tendency to classify efforts to educate the public as program expenses have led many to question whether reliance on accounting measures is counterproductive.  In terms of (i), Charity Navigator, a prominent watchdog group, has gone so far as to “undo” the accounting and allocate all joint costs toward fundraising, believing this will yield a more accurate program expense ratio.  In terms of (ii), concerns have been bolstered by high profile cases such as the Lance Armstrong Foundation and Central Asia Institute, each of which once received high praise for efficiency, only for people to later find out much of their program efficiency was due to substantial awareness/education efforts and not more “hands-on” programs.

This leads me to reach the following simple suggestion to improve accounting measures.  Accounting rules should expand functional classification of expenses to include four categories: mission, awareness & education, fundraising, and administrative.  In short, what once was a coarse measure capturing all program-related expenses could become more precise by splitting these program expenses between those that relate to primary missions and those that relate to public awareness and education.  In my view, this will help alleviate concerns about cost allocation (since virtually all of the allocations are between fundraising and awareness) and also help more fully reflect where funds are employed.  Of course, expanding functional classifications of expenses in this manner does not fully eliminate concerns about over-reliance on accounting measures, but it does at least help prevent those who do rely on the measures from being misinformed by them.

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