Nonprofits are often assailed for operating inefficiently, compared with for-profit firms. And this assertion often comes from friends of the sector. For example, one consulting firm specializing in nonprofits pitches its services with this common claim that, facing “pressure to become more efficient … nonprofit organizations today must find new ways to achieve a leaner, more businesslike operation.”
In what seem like support for this claim, standard financial ratios do not tend to flatter nonprofits. For example, one of the most common allocative efficiency measures in the for-profit world is return on investment (ROI), or net revenues divided by the value of a firm’s assets. Most studies find American for-profit firms to have an ROI of 10-25 percent. Nonprofits do not reach ROI figures even remotely close to these levels. Calculating ROI for various nonprofit subsectors using 2001 data, I find that the highest average ROI is attained by social service organizations, at three percent. Other subsectors hover around zero, and others, such as international aid, are actually negative.
So perhaps the charge of inefficiency is justified. It is certainly easy to find reasons why this might be so. Many authors, for instance, have commented on the inefficient incentive effects from the so-called “nondistribution constraint,” which prohibits nonprofit owners from appropriating net revenues. And the fact that standards of nonprofit accountability hardly exist in any coherent form can only make things worse.
Before concluding, however, that nonprofits are an efficiency disaster area, it is worth thinking a bit more carefully about what “efficient” actually means—or should mean—for nonprofits.
For-profit organizations think of efficiency in the allocation of funds in terms of getting the greatest output, given a fixed amount of inputs, or using the fewest inputs to get a fixed output. Measures like ROI are derived from this “most from the least” standard. It is appropriate for commercial firms, because we often assume that they have a profit-maximization objective. This objective is met by spending and investing up to the point that the last dollar in expenditures earns a dollar in revenues, a concept economists call “equimarginality.” (If a firm were to spend more than this, the return would be lower than the expense, lowering total profits. If were to spend less than this, it would be forgoing positive net returns on spending.)
Notwithstanding the name “nonprofit,” it would be inaccurate to suggest that these organizations cannot maximize profits. The law simply enjoins them from distributing profits to owners. However, it is reasonable to assume that effective nonprofits generally do not maximize profit. In fact, it seems counterintuitive that an effective nonprofit would produce less than it can in services every year, simply to have a larger and larger pot of savings (a point lost on many elite private universities). A better standard than profit maximization for nonprofit allocative efficiency might be that of maximizing net returns to some types of spending—fundraising expenses, for example—while maximizing core services, even in spite of negative net returns on core service spending.
An example should help clarify this point. Imagine a ballet company that raises a large percentage of its own revenues from donations. It has two kinds of expenses: fundraising, and spending on service for performances. Its mission is to provide as much service as possible (with an acceptably-high level of quality). To do so means fundraising optimally—up to the point of equimarginality—and then spending its net revenues on core services, without regard for the “return” on this latter type of spending. (Naturally, this is a simplified example. An actual organization has many types of services and expenditures, and might elect to save extra revenues some years, if possible.)
For this agency, revenues and mission are related in an interesting way. Without fundraising, if revenues are too low, mission is not met because performances cannot occur. On the other hand, if the organization focuses only on raising revenues, it will also be diverted from its mission. What it seeks is the “sweet spot” between fundraising and core services: to raise as much net revenues for service spending as possible. The for-profit efficiency criterion only seems to apply to certain portions of the agency’s costs and revenues.
To test whether nonprofits are in fact efficient under this description means looking at the return from the last dollar spent on non-core services. Standard statistical tools exist to test this hypothesis, given data on a sample of nonprofits. And the data suggest that, in fact, nonprofits appear to approach efficient non-core service spending so that they may maximize their level of services. For example, using 2000 Internal Revenue Service data on 25,000 American arts nonprofits, I find these organizations have an average return of close to a dollar in revenues for the last dollar in management and fundraising expense. For organizations in media it was $1.26; $1.58 for the visual arts; 83 cents to museums; $2.38 to the performing arts; and $1.68 to history organizations.
It is somewhat ironic that, if we were to level a charge of allocative inefficiency on the basis of these findings, it would be that arts nonprofits spend too little on non-core items, not too much, so they raise less than they could to spend on core services. Most organizations do not spend all the way down to the “equimarginal” ($1) level.
Note that I have said nothing about how well nonprofits use their revenues from fundraising. They might well spend them wastefully—inefficient to be sure. However, under a pure criterion of allocation of funds, it appears that nonprofits are not as inefficient as we might have thought after all.
The importance of understanding the nature of nonprofit allocative efficiency is two-fold. First, this understanding would allow regulators, donors, and nonprofits themselves to enrich their concept of good management practices—and provide an answer to attacks on the sector motivated by the inappropriate use of for-profit efficiency measures. Second, such an understanding opens the door to true allocative efficiency gains, which depend on the optimal management of non-core spending, such as fundraising.
Arthur C. Brooks is associate professor of public administration and Director of the Nonprofit Studies Program at the Maxwell School of Citizenship and Public Affairs, Syracuse University and a member of the NCNE Research Advisory Council.