Imagine that you’re the director of a community center that has been invited to submit a $50,000 grant request to fund a summer sports program. This would be a new effort, although it’s nicely linked to existing youth programs in the center. How can you determine whether the grant will be financially beneficial or detrimental to the whole organization? Many managers rely on intuition or incomplete information about overhead rates to answer this question. This article presents a structured method of conducting a financial cost-benefit analysis. The accompanying sidebar clarifies common misunderstandings related to the term “overhead rate.”
1. Assessing a Grant’s Full Costs and Benefits
The first step of the grant’s cost/benefit analysis is to develop a schedule of expected costs and benefits associated with the grant.
The goal is to identify every financial cost and benefit of the grant to the organization. At this stage, avoid adjusting costs based on grant constraints or the organization’s budget. On the revenue side, consider such questions as: Do the financial effects include only the grant funding or is there an opportunity for additional program service fees? On the cost side, it is relatively easy to identify readily apparent costs, such as program staff time, recreational equipment, program advertising/promotion, and grant administration.
However, the value of this step lies in identifying the unexpected costs and revenues. For example, you would find with a thorough brainstorming that the full cost of the summer grant includes not just what is immediately apparent but also such things as insurance, maintenance, and the costs of fundraising and administrative staff time. It is useful at this point to talk with others who have run a similar program to be sure you are anticipating costs properly.
At this point, it’s helpful to assess not just the immediate effects of the grant but also longer-term consequences. In our example, the grant may cover the cost of new playground equipment. The equipment provides a long-term financial benefit to current and future summer programs, but it also creates insurance and maintenance costs that will continue into the future. By quantifying the full range of financial costs and benefits before applying for a grant, management can make a better-informed decision about both the short- and long-term obligations the grant initiates.
When a grant funds only a portion of a larger program, it is generally preferable to conduct this analysis at the program level and include other program-related revenue.
At the most basic level, you should include in this step the following consideration: Applying for a grant to finance any particular project can be costly to other parts of the organization, since it may reduce the donor’s willingness to consider other projects in the near term and cause the organization to forgo other opportunities to accept this project.
2. Distinguishing Between New and Existing Financial Effects
The second step in performing the cost/benefit assessment is to divide the financial costs and benefits between new and existing items. The objective here is to distinguish the costs and revenues that will occur only if the grant is obtained from those that are predetermined or fixed. It is the new or incremental costs and revenues that will be relevant in the later steps.
In our grant example, the committed costs include the existing mortgage, maintenance, insurance, and salaried staff time.
The new or marginal items include the class registration fees collected on the new programs as well as the cost of an additional summer program staff member, new playground equipment, incremental printing and mailing costs, and repairs to a basketball court. It also is important to identify the future recurring costs and revenues, such as the increased insurance premiums, added maintenance costs, the summer program staff member, and registration fees.
The final list of new or incremental costs should include both the one-time costs and a portion of the new recurring costs. The recurring costs that are included depend on the grant’s allowable scope and the nonprofit’s plans for covering the ongoing costs in the future. In our example, the nonprofit may decide to include the increased insurance and maintenance for the full year as a new marginal cost. It may be able to limit the future recurring costs by deciding that future registration fees and a fundraiser will be required to cover the costs of running the program in future years.
3. Conducting a Break-Even Analysis
At this point, it’s useful to compare the new or marginal costs to a realistic estimate of the eventual grant amount and new revenues. The goal is to determine if the grant will break even financially. Ideally the grant and new revenues should equal or exceed the new costs. Any excess of the grant over these costs contributes to the organization by covering existing costs or the excluded future recurring costs. While a nonprofit can pursue some grants that are close to or even below break-even, the organization needs enough funding with positive contribution margins to cover its committed costs. So some organizations determine a pre-set contribution margin, or hurdle rate, in order to approve a grant.
If the break-even analysis determines that the marginal costs are greater than the grant amount, then the plan should be revised. This phase of the analysis often results in reducing the scope and extent of new activities that will be funded by the grant. Alternatively, the nonprofit can pursue supplemental sources of revenue, such as contributed goods and services, donations and fee-for-service arrangements, to cover the shortfall.
In our example, suppose the nonprofit estimates that the grant will be $50,000 and the incremental registration fees will generate $10,000. The repairs, playground equipment, summer staff member and program promotion total $52,000, and a year of increased insurance and maintenance equals $3,000. So the marginal revenues of $60,000 exceed the marginal costs of $55,000. The difference of $5,000 (or 10 percent of the grant) can be used to cover existing costs. The 10 percent often is referred to as the “contribution margin.”
4. Deciding If the Grant Fits the Organization
Upon seeing the favorable contribution margin, many managers proceed immediately to preparing the grant budget. But it’s important to examine the grant’s role in the organization first. The attractiveness of applying for a grant with a particular contribution margin depends upon the fit with mission, other funding options, and the organization’s financial condition and uncertainties.
An analysis of organizational fit helps ensure that managers put the grant in perspective. Grant proposal writers are eager to obtain a particular grant. As a result, the fundraising appeal often emphasizes that certain programmatic activities cannot occur without the funding. Grantors, too, want to hear that their funds are bringing about some new positive change. Hence, the organization feels pressure to request grants that primarily fund new costs.
In our example, a 10 percent contribution margin seems attractive. Suppose, however, that the funder would be equally willing to provide the $50,000 without the expanded summer course offerings or the repairs to the basketball court. A financially struggling nonprofit might prefer this second option, since the contribution margin is higher, even if does not expand the programmatic impact of the organization.
Some groups have a tendency to focus on obtaining the latest grant rather than ensuring complete funding for the program. Managers tend to include the most appealing costs in the immediate grant proposal and often underestimate them. This may leave a set of costs that no donor is willing to fund. Hence, it’s important to determine if there will be stranded costs and how they will be financed. Without forethought, the community center could be financially burdened, for instance, with increased insurance premiums and maintenance costs.
Along with considering financial costs and benefits, the organization should consider the effect of the grant on the mission and on the organization as a whole. A funding opportunity may support a program that is central to the mission, or it may shift the mission, thereby alienating some constituents or diffusing the impact of the organization. The grant also may place demands on staff time, distracting them from other mission-critical activities. Finally, the enhanced program may create a set of expectations—rightly or wrongly—among the community, board members and employees that the program will be continued in the future. If the program is likely to be sustained, then the organization should include the costs of asset replacement and ongoing program fees in its list of financial effects.
At the conclusion of this step, the nonprofit should have a good understanding of how the grant relates to particular programs and to the organization as a whole. Ideally, the grant will cover new costs, including some contingencies, while also contributing to both the mission and the financial health of the organization.
5. Preparing the Grant Budget
The final step is to produce the grant budget. This is essentially the pricing phase of the analysis. Since most donors expect costs to be divided between direct and indirect costs, the budget generally includes this breakdown. Some grant writers assume that the only costs that can be listed as direct are those that are both new and program-related. A careful review of the application instructions can determine whether this is true. Many donors do not require or expect that the direct costs be new. Others allow costs such as an external program evaluation to be classified as direct. In other instances, any identifiable costs, including grant administration, rent and supplies, can be listed as direct costs. Hence, the classification of costs between direct and indirect in the grant proposal may not correspond strictly to either a program-support services distinction or to a new-versus-committed cost breakdown. So the stated indirect costs for the summer sports grant could be $5,000, as in the break-even analysis, $8,000 if the insurance and maintenance are included, or even higher if the repairs or promotional costs are classified as overhead.
Some donors have a preference for grant proposals that include little or no stated overhead. It’s wise to be cautious and to examine and compare details. If you compare the stated overhead rate in a grant to the percentage of organizational expenses that are classified as general overhead and the grant rate is higher, it cannot be assumed that all the overhead costs are covered and that you can now proceed with the grant. Definitions differ broadly because many grant makers have their own guidelines that determine whether a cost is classified as direct or indirect. It’s best if you keep in mind that the indirect costs stated in a grant represent the price you set (as allowed by the funder), not necessarily a true cost. It is simply an amount that the applicant hopes to receive from the donor.
Many executive directors, fundraisers and program staff want to know their agencies’ overhead rate to help them determine the attractiveness of various funding opportunities and for internal management purposes. When questioned for this rate, the finance staff inevitably answers, “That depends who’s asking.” This response mystifies and often frustrates, for it would seem that the finance staff should know exactly what the overhead rate is.
However, there is no consistent definition of the overhead cost rate because there are differences in how funders and others expect it to be computed. The rate is composed of overhead costs (which may include more or fewer categories depending on the definition being used) in the numerator and a benchmark amount in the denominator—all costs of a grant, of the associated program or of the agency as a whole.
While the appropriate benchmark or denominator may be easy to select given the reason for the analysis (Are we looking at the whole organization or just a part?), there is considerable variation in what constitutes the numerator, i.e. overhead costs. While the term “overhead” refers to the indirect cost of an organization’s products and services, in a nonprofit setting, it can be used to mean administrative expenses, fixed costs (such as salaries and rent), or the amount stated in a grant application. Rather than labeling all three concepts as “overhead,” some try to reduce misunderstandings by referring to them as support service expenses, committed or fixed costs, and indirect cost recovery, respectively.