Are overhead costs a good guide for charitable giving?
Charity rating agencies often focus on overhead cost ratios in evaluating charities, and donors appear to be sensitive to these measures when deciding where to donate. Yet, there appears to be a tenuous connection between this widely-used metric and a charity’s effectiveness. There is evidence that a focus on overhead costs leads charities to underinvest in important functions, especially skilled workers. To evaluate policies that regulate overhead costs, it is necessary to examine whether donors care about overhead costs, whether they are good measures of charity effectiveness, and what effects a focus on overhead costs has on charities.
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The overhead cost ratio is the most commonly used metric to rank charities. However, for most charities, it is a crude measure that does not adequately evaluate their effectiveness. Despite the fact that broader measures of impact are far more meaningful, donors exhibit strong distaste for high administrative costs. Excess focus on these costs can lead charities to underinvest in crucial operating infrastructure, especially skilled workers, thereby diminishing their ability to deliver services. Policymakers should avoid these simplified measures, striving instead to utilize better impact metrics, despite their enhanced complexity and costs.