Are US lawmakers right to challenge USAID overhead spending?

Should development organizations spend less money on overhead? Or should they spend more? This longtime debate in the development sector swung back into focus in April, when two United States Republican lawmakers wrote to the U.S. Agency for International Development, saying they were worried the agency had dropped the ball on overheads — that suppliers were padding their funding proposals with unnecessary admin costs, and the government was getting bilked. Looking around the world, the lawmakers could be forgiven for getting that impression. They say that USAID can often pay a quarter of project costs as overhead. But the European Union commonly allows only 7% of project costs to be allocated to overheads, many United Nations agencies also only pay 7%, and big philanthropic foundations such as the Bill & Melinda Gates Foundation have historically allowed 15% or less. Why, one might ask, is USAID so much more generous? How come, if suppliers are able to provide services to the EU at one rate, they are charging the U.S. so much more? But sector representatives offer a simple answer: USAID’s rates are probably closer to the true cost of overhead, and other funders are underpaying. Funders’ failure to properly fund overhead, they say, means development organizations end up either concealing it in project costs, subsidizing government expenditure from other funds, or cutting important expenditure to balance the books. And by putting pressure on overheads, those funders are preventing grantees from building skills, maintaining proper reserves, and properly managing risks such as data breaches and fraud, making them less efficient in the long term — a concept known as the starvation cycle. The letter of the lawmakers The most recent complaint, from Iowa Sen. Joni Ernst and Texan Rep. Michael McCaul, concerned NICRAs — negotiated indirect cost rate agreements. These are common arrangements which document a U.S. government supplier’s non-project costs, and the compensation they can receive for those costs on top of project funding. The actual rates are unique to each organization, vary quite widely, and are closely guarded secrets. Lawmakers said they were worried these figures could “easily exceed 25% of an organization’s total award” and demanded in a letter that USAID supply NICRA information to the influential Foreign Affairs Committee of the U.S. House of Representatives for review. They expressed concern that U.S. government dollars were being “unduly wasted on paying for awardee’s rent in Geneva or Rome or Paris.” USAID has now said it will provide some information to the committee, although exactly what is unclear — whether the data will be anonymized or aggregated in some way, or be accompanied by explanation or commentary. Sector experts say no one is making bank because of NICRA. Some representatives said many organizations, no matter their size or power, struggle even to get institutional donors to fully compensate them for the cost of their projects — a concept known as full cost recovery. While others said one of the biggest causes of overhead is in fact government demand for compliance on a wider range of issues, from modern slavery to sanctions, which lawmakers insist on inserting into contracts but then begrudge paying for. Tim Boyes-Watson, director and co-creator of Fair Funding Solutions, a development consultancy, who supported the creation of a United Kingdom standard for overheads, said NICRA was seen as “as good as it gets in the world of government funding NGOs at providing close to full cost recovery” and that as a result, when the U.K. government developed its own model, it deliberately emulated many elements of NICRA. What’s the right rate of overhead? Overhead in a development organization covers many things: premises, technology, management, and functions such as finance, business development, HR, and safeguarding. Since each organization has different needs in these areas, there is no single right rate of overhead. But there is a clear ballpark. Advisory firm Bridgespan, which advocates “pay what it takes” philanthropy, said the real median overhead for a nonprofit is around 40% of direct costs. Meanwhile, the MacArthur Foundation carried out research with financial data from 130,000 nonprofits in the U.S. and found “the minimum indirect cost rate associated with financially healthy organizations” was 29%. A growing body of research in the United States takes aim at the “overhead myth” — that lower overhead in a nonprofit equals greater efficiency. Researchers in the U.S. say that historically it has been difficult to measure the true impact of development activity — and nonprofit activity more widely. As a result, “fiscal probity” has been used as a proxy for effectiveness. “Since the U.S. is a major donor and wields a lot of influence at the United Nations, I’m always surprised they aren’t applying more pressure for the U.N. to reform.” --— Tim Boyes-Watson, director and co-creator, Fair Funding Solutions, Nonprofits have then compounded the problem themselves by downplaying their need for overhead, telling supporters on their websites or in adverts that all donations will go to the front line. But sector leaders say that inefficiency is more likely to be created by a lack of overhead than by an excess of it. A report published by MacArthur last year said the foundation “realized that its longstanding policy mandating a 15% cap on indirect costs in project grants was contributing to the starvation cycle for its own grantees.” The foundation has now revised that overhead rate to 29% on project grants to all grantees — and is one of an influential group of philanthropic foundations telling NGOs it’s okay to spend more on overheads. Some of these organizations have gone further than increasing overhead allowances. Like MacKenzie Scott, they’ve moved to a “trust-based” model of philanthropy — giving an organization an unrestricted grant, with the freedom to spend as much as needed on overhead — or anything else. The problems of scale Research found that overhead costs are higher, and the problem of recovering them more pronounced, for smaller organizations — and even more pronounced for small, local NGOs. This may be both because they cannot use economies of scale to bring costs down, and that they cannot recover costs as effectively. There are several potential reasons for this. For example, smaller business development teams may have to negotiate with funders from a weaker position, and it may be harder to access strategies that produce unrestricted income, such as trading via thrift shops or raising cash from the general public, with lower brand familiarity. Smaller organizations may also struggle with full cost recovery because they struggle to work out what their overhead rate actually is. This is a surprisingly difficult calculation, which requires skilled finance staff and strong accounting software — things which are hard to find cash for, because they are viewed as overhead. Sub vs prime Local NGOs are also much more likely to receive subawards, and get a share of overhead only once a prime awardee has taken a cut. Research completed in 2022 by Development Initiatives, an organization focusing on data and development, found many U.N. agencies and INGOs did not have policies on overhead costs for local subs, although a follow-up mapping exercise found that more policies are being developed. But will it help, if INGOs are expected to pass on administration costs on their projects to their local subs? If they are not achieving full cost recovery themselves, what will they do if they are forced to pass on more money, without any rise in their own grants? “That is an existential risk to some INGOs, and could disincentivize them from partnering at all,” said Fran Girling, senior policy and engagement advisor at Development Initiatives. Doing things differently So what happens when donors set an indirect cost rate that is too low? In this case, Boyes-Watson said, NGOs will usually claim the maximum allowable and then make up the funds from elsewhere, as well as reattributing as much overhead as possible into direct costs, by allocating rental costs or the costs of support staff to a particular project. This wastes a lot of development organizations’ time and money, by forcing them to report against different complex requirements for each donor. But another problem is that the U.S. government, in particular, expects partners with a NICRA to account for overhead consistently across the whole organization — making it extremely hard for a U.S. aid agency to take on an EU contract, with its completely different cost recovery expectations. It is possible, Boyes-Watson said, to find solutions to circumvent this requirement, but that such measures also strain development budgets. The solution, he said, would be for all major funders to agree to a common system of measuring overhead. And he said there is an opportunity to do so at the moment, because discussions are already well under way to develop a common system for nonprofit accounts, which could include a single method for tracking overheads. Since accounts are independently audited, donors could rely on the auditors to check that overhead rates were being properly applied. “Then both the NGO and the funder would know they were paying a fair rate and everyone feels fine,” Boyes-Watson said. This change might prove tricky in practice — it would involve persuading a large number of inflexible bureaucracies to sign up to the same standards — but it would benefit more generous overhead funders such as USAID. “Despite all this talk about gaming around the edges, if you're getting 30% from one donor and 7% from another, there is probably some cross subsidy going on,” Boyes-Watson said. “So it should totally be in the U.S. government’s interest to have other donors adopt something like this.” Getting the EU on board, he said, may prove a challenge, as will convincing its largest contributors — France and Germany. But the United Nations may prove easier. “Since the U.S. is a major donor and wields a lot of influence at the United Nations, I’m always surprised they aren’t applying more pressure for the U.N. to reform,” he said.