A step toward supporting the true cost of nonprofits’ work

Most Hewlett Foundation grants are given as general operating support or flexible programmatic support, and we want grantees to use our dollars flexibly as they deem best to achieve our mutually shared goals. When restricted project grants have been made, we have left the determination of indirect cost recovery to case-by-case negotiation between the grantee and our program officer. We have never set a foundation-wide minimum or maximum rate for indirect costs.

We adopted this approach in accord with our guiding principles, which emphasize working collaboratively and in partnership with grantees and seeking to facilitate rather than dictate what they do. That only works, however, if our program staff and grantees have open, candid conversations about the true costs of restricted grants. And while that may usually be the case, sometimes those discussions don’t take place, and sometimes grantees submit proposed project budgets with a low rate, possibly worried that asking for more will jeopardize their grant. Maybe that shouldn’t surprise us, given the sector’s general norms and the absence of a clear policy on our part. The result, in any event, has been to allow unstated assumptions and conventional (mis)understandings about costs to produce an unintended consequence, and we are not always paying our fair share of the work we have asked grantees to do.

We learned as much in our most recent Grantee Perception Report, which for the first time explicitly surveyed grantees about indirect costs. Respondents described the process for setting these costs as straightforward, but 34 percent reported that our grant failed to cover all their indirect costs and 11 percent said the grant didn’t cover even the direct costs of the work. Worse, 23 percent disclosed that indirect costs were never discussed.

We can do better.

A field-wide challenge

And not just us. The challenge of inadequate cost recovery afflicts our whole sector and has for many years. A decade ago, Ann Goggins Gregory and Don Howard published “The Nonprofit Starvation Cycle” in the Stanford Social Innovation Review, in which they observed:

A vicious cycle is leaving nonprofits so hungry for decent infrastructure that they can barely function as organizations—let alone serve their beneficiaries. The cycle starts with funders’ unrealistic expectations about how much running a nonprofit costs, and results in nonprofits’ misrepresenting their costs while skimping on vital systems—acts that feed funders’ skewed beliefs. To break the nonprofit starvation cycle, funders must take the lead.

In the years since, there has been much discussion, but little action.

As we investigated further, alongside other funders and sector experts, we learned that grantees’ true indirect costs nearly always exceed the limits set by funders on indirect costs. We also became more aware of significant inconsistencies among funders and nonprofits and in the social sector generally when it comes to language, definitions of terms, and methodological approaches to calculating costs.

The whole system is peculiar, if you think about it. In other settings, providers of goods and services set their prices, and people who want them must decide if they are willing to pay or want to find a cheaper alternative. We don’t negotiate the price of a cup of coffee with Starbucks or the cost of services from our dentists, and there is no particular reason this common pricing model is not used in the world of non-profit funding. The U.S. government adopted the practice of distinguishing direct from indirect costs as a condition for its funding after WWII, and foundations simply followed suit.

They did so, however, with one important difference: the government also adopted a practice of negotiating an indirect cost rate agreement (or NICRA) with each recipient. This rate, which can be as high as 65 percent and seldom dips below 25 percent, is designed to ensure that legitimate expenses are covered. No similar practice emerged among philanthropic funders, and different foundations employ different approaches to handling indirect costs. These run the gamut from paying only direct costs to leaving the matter to grant-by-grant negotiation. The most common practice by far is to allow indirect costs under fixed formulas that we now know from repeated research findings are manifestly inadequate.

Our approach

Our grantees cannot achieve the results we mutually desire if they are not financially healthy. To help in that effort, we are publishing a new policy on indirect costs with the goal of providing greater clarity for organizations submitting grant applications. It may also, we hope, contribute to improving practice across the sector generally.

The policy does not create a new formula: if anything is clear from the research, it is that no pre-determined formula can adequately or accurately capture the wide variations that exist in a sector comprised of organizations that work in so many different ways, with so many different missions and business models. Rather, within broad guidelines, we invite grantees to engage with us in a candid conversation to honestly assess the true costs of what we and they want to do.

We seek to avoid the pernicious nonprofit starvation cycle with our grantees. When proposals require grantees to submit budgets with indirect costs estimates, we want the proposals to reflect the prospective grantees’ actual indirect costs for the project or program in question.

We recognize that every grant has a unique purpose and structure and that costs vary depending on many factors. We set each grant’s total amount with the grantee in the context of our overall grantmaking budget and funding priorities. As part of that process, we intend for grantees to take the lead in determining how best to allocate those grant dollars to direct and indirect costs, albeit in consultation with us.

Under our new policy:

• U.S. nonprofit organizations: We will either accept the indirect cost rate presented in a grantee’s proposal or discuss it further with them if we need to learn more. We do not set a fixed maximum or minimum allowable rate for cost recovery.
• Universities: We will presumptively accept an indirect cost rate of 10 percent of the total grant amount. If an indirect cost estimate exceeds 10 percent in ways that can reasonably and transparently be attributed to costs fairly associated with the program or project in question, we will make an exception and accept an indirect cost amount greater than 10 percent.
• Regranting organizations: Grantees with regranting programs should include an indirect cost rate appropriate to the effort required to execute their sub-granting. We strongly encourage these grantees to examine their own policies on indirect costs and follow a similar practice in their grantmaking.
• Fiscal sponsors: Grantees serving as fiscal sponsors should include an indirect cost rate appropriate to the specific project for which they are acting as sponsor and sufficient to cover the administrative costs of that project.
• Organizations outside the United States: Accounting standards vary in other countries, but we encourage grantee organizations working outside the United States to provide an indirect cost estimate in line with the true cost principles described above.
• For-profit organizations: The U.S. tax code requires that any grant funds awarded by a private foundation to a for-profit organization be dedicated to accomplishing a charitable, educational, or scientific purpose. The indirect cost estimate from for-profit organizations should reasonably and transparently reflect any and all indirect costs attributable to the charitable purpose of the grant, but only those specifically attributable to that purpose.

The application of these general guidelines may not always be evident, and we encourage grantees and potential grantees who have questions to consult with their program officer at any time.

Along with this policy, we are now working internally to train staff and further develop our skills and capacity to assess costs accurately. We also continue working with our fellow funders—a collaboration that is growing—to share experience and learn from each other. Our goal remains to act fairly and consistently and to create an environment that invites honest and constructive conversations, so we reliably pay our fair share of the projects we fund. We look forward to and welcome an ongoing dialogue as we learn.