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Abstract

Whereas the field of public administration has benefited from periods of critical reflection and reform aimed at reexamining the field’s traditional management paradigms, the related field of nonprofit management has generally lacked such an analogously explicit and sustained research program to reevaluate its own conventional wisdoms. Meanwhile, accumulated findings from the last several decades of nonprofit management research have problematized many traditional assumptions and practices in nonprofit management, specifically regarding the soundness of nomothetic management theory, the unintended negative consequences of certain management norms, and underlying assumptions about the nature and purpose of nonprofit management. This article critically reexamines four well-known “proverbs” of nonprofit financial management—minimize overhead, diversify revenues, be lean, and avoid debt—to demonstrate the need for a critical and reflective research program that takes stock and reconsiders the field’s foundational principles and assumptions. Implications are derived for scholars and practitioners, as well as for information intermediaries that evaluate nonprofits based on financial information.

Keywords

nonprofit financial management overhead diversification reserves debt

Public administration scholarship increasingly accepts that meeting public needs often depends on collaborative governance arrangements between public and nonprofit actors (L. M. Hall & Kennedy, 2008; Marwell & Calabrese, 2015; Mitchell, 2014). Indeed, significant levels of public services are routinely provided through public–nonprofit contracting (S. R. Smith & Lipsky, 2009). As the field of public administration has evolved and adopted more expansive notions of governance (Ansell & Gash, 2007; Bingham, Nabatchi, & O’Leary, 2005), it has also demonstrated a robust history of critical reflection and periodic reform initiatives (e.g., Meier, 2015; Meier & O’Toole, 2008; Simon, 1946), albeit with mixed results (Williams, 2000). However, the field of nonprofit management has generally lacked analogous and sustained efforts at stocktaking and reform. Whereas public administration scholars continue to critically evaluate the paradigm of “reinventing government” through “New Public Management,” for example, less concerted effort has been directed toward reconceptualizing and reevaluating dominant paradigms in nonprofit management.

In the spirit of analytical reflection and reform, this article critically examines several “proverbs” representing conventional wisdoms about nonprofit financial management. This exercise identifies a historically normative approach to nonprofit financial management focused on maintaining organizational “trustworthiness” through “appropriate” financial management practices. However, nonprofit management research accumulated over the past several decades reveals that many of these traditional norms and practices significantly inhibit the ability of nonprofits to achieve a variety of important strategic objectives. A critical analysis of the proverbs in light of contemporary nonprofit management scholarship demonstrates the need for a reflective and constructive research program that reconsiders (a) the soundness of nomothetic management theory, (b) the unintended negative consequences of proverb adherence, and ultimately, (c) underlying assumptions about the nature of the nonprofit organization and the purpose of nonprofit management.

This article is organized as follows: The section “Theoretical and Empirical Context” provides an overview of the context in which proverbs of nonprofit financial management have emerged. This is followed by the section “Reexamining Proverbs of Nonprofit Financial Management” with critical reexamination of several well-known proverbs: (a) minimize overhead, (b) diversify revenues, (c) be lean, and (d) avoid debt. The subsequent section “Discussion” then reconsiders the theoretical context in which the proverbs are nested. Finally, the section “Conclusion and Implications” recapitulates main insights, raises additional questions, and offers recommendations for future research.

Theoretical and Empirical Context

The “standard theory” of the nonprofit characterizes nonprofits as specialists in the production of unobservable, and therefore noncontractible, outcomes. According to Weisbrod, society delegates to public and nonprofit organizations the production of precisely those outcomes for which performance information is “unobtainable or excessively costly” (Weisbrod, 1988, p. 47). Canonically, Hansmann (1980) proposed that nonprofits have a comparative advantage in the production of such outcomes because nonprofits are subject to the “nondistribution constraint” or prohibition against private inurement, which renders them more “trustworthy” than other institutional forms, such as for-profits. Self-interested managers might otherwise exploit information asymmetries through shirking or graft. The risk of exploitation is especially acute for donative nonprofits in which there is a separation between donor and recipient, further complicating surveillance. Weisbrod (1988; Weisbrod & Schlesinger, 1986) similarly emphasized the importance of the nondistribution constraint for establishing the trustworthiness of nonprofits under conditions of information asymmetry.

However, the nondistribution constraint also introduces an efficiency problem. Fiscal surpluses cannot be retained for personal benefit due to the prohibition against private inurement, and neither can compensation be tied to performance because observing outcomes is too costly or would be too behaviorally distortive. Managers, therefore, have diminished incentives to manage resources efficiently. As such, “inefficiency is inherently embedded in nonprofit services” (Y. H. Kim & Kim, 2016, p. 2942). However, this inefficiency is to be tolerated because the costs of incentivizing efficient performance would (presumably) outweigh the benefits (Weisbrod, 1988).

The standard theory of the nonprofit rationalizes specific managerial imperatives to maintain organizational trustworthiness under conditions of outcome unobservability. Trustworthiness is conventionally signaled through demonstrations of fiscal propriety, such as visible salary suppression, high program expense ratios and low overhead, risk aversion, debt avoidance, reserve minimization, and generally the maximization of current direct program spending (Mitchell, 2016). The standard theory developed by Hansmann and Weisbrod is, in essence, a formalization of the historical view of nonprofits as they were understood through the end of the twentieth century as stewards of expressive almsgiving.¹

However, the nonprofit sector has changed significantly over the past decades. Nonprofits increasingly face competition from for-profits in fields previously dominated by nonprofits, especially in health care, education, child care, and job training (Salamon, 2010). Furthermore, growing intersectoral competition with for-profits has increased performance pressures and expectations for measuring outcomes. Tuckman (1998), for example, notes that intersectoral competition is likely to cause nonprofits to adopt more “for-profit business techniques” and to “deliver services efficiently” to remain competitive (p. 187). Furthermore, private contributions and voluntary action are no longer the dominant paradigms for funding or staffing many nonprofits. P. D. Hall (1999) documents the decline of traditional voluntary organizations funded primarily through contributions and reliant on volunteer labor over time. In 2013, for example, about 22% of sector revenue came from donations, whereas almost 70% of revenue was earned from program services.²

At least in part, these shifts derive from the nonprofit sector increasingly providing services that government historically provided. For instance, Kettl (2000) notes how welfare reform led to the devolution of services from the federal government to the states, and in turn from the states to lower levels of government and eventually nonprofits. Millward and Provan (1993) observe how governments have turned hospitals, mental health clinics, parks, prisons, water treatment facilities, and transportation systems over to private entities, including nonprofits. This trend of contracting out public services is hardly new and has been widely documented in public administration and nonprofit management scholarship (e.g., Brudney, 1990; Marwell & Calabrese, 2015; Salamon, 1981; S. R. Smith & Lipsky, 1993; Stillman, 1990). This practice expanded significantly during the 1980s as public services were privatized and efforts to apply business management practices in government intensified throughout the 1990s (Box, 1999). In essence, nonprofits assumed more “publicness” during this period (Bozeman & Bretschneider, 1994).

As a result, concerns about the effectiveness of governments in meeting citizen demands are increasingly entangled with nonprofit performance. The result is that the environment of nonprofit management appears to be shifting from one emphasizing organizational trustworthiness and fiscal propriety to an emerging context increasingly characterized by explicit expectations for nonprofits to demonstrate their effectiveness and efficiency.³

This also raises questions about certain axioms of the standard theory of the nonprofit. For example, outcome unobservability is supposed to preclude the possibility of contracting, yet government–nonprofit contracting has become pervasive and commonplace. Government at all levels finance significant portions of many nonprofits’ budgets through contracts (Lipsky & Smith, 1989; Salamon, 1987). Between 1977 and 1997, government funds increased from 27% to 37% of all nonprofit revenues (Salamon, 2010), representing the largest area of revenue growth for the sector. Even following government retrenchment after the Great Recession, public funds still account for well over 30% of sector revenues (McKeever, 2015). Indeed, nonprofits routinely deliver services financed by public funds through contracts, fee-for-service arrangements, and grants (S. R. Smith & Grønbjerg, 2006).⁴

Rather than relying primarily on their trustworthiness, many nonprofits must also fulfill formal contracts with well-defined outcomes and demonstrate their effectiveness and efficiency through program evaluation. With the continued professionalization of nonprofit management and growing interest in social entrepreneurship and outcome-oriented philanthropy (Brest, 2012; Martin & Osberg, 2007; Mitchell, 2016; O’Flanagan, Harold, & Brest, 2008; Schmidt, 2014), the managerial imperatives pursuant to the standard theory of the nonprofit as a trustworthy agent may be providing decreasingly relevant guidance for many nonprofit practitioners, particularly those with an instrumental, rather than a normative management orientation (Mitchell, 2016).

Nonprofit management research itself increasingly challenges the field’s own conventional wisdoms, especially the well-known proverbs and rules of thumb that have historically defined “appropriate” nonprofit financial management practice. Aided by decades of research made possible through the public accessibility of nonprofit financial disclosures, the establishment of new research centers on nonprofits, philanthropy, and civil society, a growing international network of professional nonprofit management scholars, mature academic journals for scientific nonprofit research, and a cultural shift toward more evidence-based and results-oriented approaches, findings from accumulated nonprofit management research now appear to challenge many traditional assumptions. Three of these assumptions are highlighted in this article.

First, nonprofit management theory has historically assumed a nomothetic character, effectually rationalizing universal management imperatives emphasizing the targeting of fixed benchmarks and specific rules of thumb. For example, information intermediaries such as Charity Navigator (www.charitynavigator.org), the Better Business Bureau–Wise Giving Alliance (www.give.org), and CharityWatch (www.charitywatch.org), and periodicals such as Forbes Magazine (www.forbes.com/top-charities/list/) and Christian Science Monitor (https://www.csmonitor.com/Business/Guide-to-Giving), variously rate, rank, or otherwise convey the extent to which nonprofits adhere to long-standing sectoral norms such as overhead minimization, salary suppression, debt avoidance, and reserve minimization. In addition, and as described below, academic scholarship has often perpetuated problematic norms in empirical research, such as employing cost ratios as efficiency measures, even though they take no account of outputs or outcomes.⁵ Specific examples discussed in the following section destabilize the underlying assumption that a field of nonprofit management can be built on nomothetic proverbs. This mirrors analogous efforts in public administration critically reexamining the nomothetic approach associated with Luther Gulick and others, which has been widely criticized (Meier, 2015; Meier & O’Toole, 2008; Simon, 1946).

Second, contemporary nonprofit scholarship has discovered significant negative unintended consequences of traditional proverb-following as organizations have attempted to demonstrate fiscal probity and trustworthiness through conformity to nomothetic rules. As discussed extensively below, this problematic behavior can reduce organizational effectiveness and efficiency, stunt organizational growth, and exacerbate fiscal deprivation, volatility, and vulnerability, among other consequences.

Third, these observations and effects arguably reveal fundamental inconsistencies between the standard theory of the nonprofit (and the nonprofit’s current institutional form, the 501(c)(3) public charity), on the one hand, and putative assumptions that nonprofits exist to benefit society, not just donors, on the other. As argued below, many managerial imperatives attendant to the standard theory appear to be counterproductive to the maximization of societal benefit. This reveals contradictions between the expressive and instrumental dimensions of nonprofit organizations (W. C. Gordon & Babchuk, 1959) and raises questions about the extents to which nonprofits are to be regarded as vehicles for warm-glow giving (Andreoni, 1990; Crumpler & Grossman, 2008), social anxiety alleviation (Seibel, 1996), outcome-oriented philanthropy (Brest, 2012), or perhaps something else entirely.

As public administration, public policy, and medicine have all undergone challenges to their established assumptions and norms (Meier & O’Toole, 2008), this article argues that nonprofit financial management praxis also requires reexamination. Indeed, the appeal of B-Corporations (for-profit corporations that have a social mission), L3Cs (low-profit limited liability corporations), and various other hybrid forms and “social enterprises” may be symptomatic of a potential inadequacy of the traditional model of the public charity.⁶ The attractiveness of these new vehicles to outcome-oriented philanthropists and social investors raises questions not only about the culture and practice of traditional nonprofit management but also about a cultural and regulatory architecture that may no longer be meeting the needs of an evolving society.

The following section identifies several specific areas where conventional proverbs of nonprofit management have been problematized by modern research, revealing inconsistencies that warrant further examination. The analysis focuses on nonprofit financial management practices where nomothetic rules are most concrete and rigorous scholarly evidence is most abundant.

Reexamining Proverbs of Nonprofit Financial Management

To demonstrate organizational trustworthiness, nonprofit managers conform to a variety of proverbs of nonprofit financial management. These proverbs include the imperatives to (a) minimize overhead, (b) diversify revenue, (c) be fiscally lean, and (d) avoid debt. Although these four proverbs are clearly not exhaustive, they collectively capture the core components of the fundamental accounting equation, which recognizes that assets equal liabilities plus net assets. Specifically, overhead minimization and revenue diversification focus on the use or accumulation of organizational wealth (net assets), fiscal leanness pertains to asset accumulation, and debt avoidance relates to liabilities (and, by extension, also net assets because all assets must by definition be financed by debt or equity). Hence, the four proverbs span the full financial management spectrum by considering the entire fundamental accounting equation. We reconsider these proverbs below, describing how changes in context and findings from contemporary empirical research complicate and challenge their conventional wisdom.

Minimize Overhead

While nonprofit spending is presumably undertaken to generate meaningful outcomes consistent with an organization’s charitable purpose, measurement and reporting has instead traditionally focused on expenditures and cost ratios, reorienting attention from program outcomes to program spending. Decades ago, Weisbrod (1988) warned of the “distorting effects of rewarding measurable proxies rather than the behavior one wants to encourage” (p. 51) while Anthony, Dearden, and Bedford (1984), lamenting the lack of outcome measures for nonprofit organizations, warned that “care must be exercised to avoid undue reliance on” (p. 758) cost figures as proxies. However, these are the very indicators on which regulators and other stakeholders have come to rely, despite an absence of empirical evidence that low overhead (a) enhances the ability of nonprofits to achieve impact (improves effectiveness) or (b) reduces total costs per outcome (improves efficiency). Neither does low overhead logically entail organizational effectiveness or efficiency. A nonprofit with relatively low overhead could have ineffective and inefficient programs, just as a nonprofit with relatively high overhead could have relatively effective and efficient programs. Because cost ratios do not account for program outcomes, they cannot measure outcomes or the costs per outcome. As a proxy for organizational effectiveness and efficiency, overhead lacks both predictive (empirical) and construct (logical) validity.

According to Weisbrod’s (1975, 1988) characterization of the nonprofit as a specialist in the production of unobservable outcomes, outcome measurement is axiomatically too difficult, costly, or distortive to undertake. In the absence of this information, and despite his own warnings, more easily measurable cost ratios have become substitutes for measures of organizational efficiency and effectiveness, with high overhead interpreted to indicate diversions of resources away from current programs (Tinkelman, 2006).⁷

Nonprofits in the U.S. meeting or exceeding certain financial thresholds are currently required by the Internal Revenue Service (IRS) to allocate their costs across functional expense categories of administration, fundraising, and programs. These allocations are reported on nonprofits’ Forms 990, which are publicly available and widely scrutinized. Various functional expense ratios related to “overhead”—such as the ratio of administrative expenses to total expenses (the administrative expense ratio), the ratio of fundraising expenses to total expenses (the fundraising expense ratio), the ratio of administration and fundraising expenses to total expenses (the traditional “overhead” ratio), the ratio of total expenses to program expenses (the “price” of giving), and the ratio of program expenses to total expenses (the program expense ratio)—have become de facto proxy indicators of organizational effectiveness and efficiency throughout the sector. Absent credible and objective information about nonprofits’ outcomes and outcome costs, overhead rates have filled the void that more meaningful measures might otherwise occupy. This combined with the widespread availability of overhead information and an ostensible air of credibility from nominal IRS oversight⁸ have contributed to an emphasis on the overhead rate (or the program expense ratio) as a chief indicator of a nonprofit’s “worthiness.”

Influential stakeholders rigorously enforce the proverb of overhead minimization. For example, the online information intermediary Charity Navigator limits overhead to 8% to 18% (depending on the subsector) to earn its highest rating (Charity Navigator, 2016), CharityWatch considers 25% or lower to indicate “efficiency” (CharityWatch, 2016a), the BBB Wise Giving Alliance imposes a 35% threshold for accreditation (BBB Wise Giving Alliance, 2016), and Forbes Magazine, which provides rankings of larger nonprofits, advises potential donors that overhead rates exceeding 20% are unreasonable (Eisenberg, 2016).⁹ Regulators, too, play an important role in norm enforcement. In Oregon, for example, nonprofits with overhead rates exceeding 70% for 3 years are disqualified from tax exempt status (L. H. Mayer, 2016). None of these intermediaries takes account of organizational outcomes.¹⁰

Given how overhead has been socially constructed as an indicator of nonprofit worthiness, it may come as no surprise that donors reduce donations to nonprofits with higher overhead (e.g., Callen, 1994; T. P. Gordon, Knock, & Neely, 2009; Jacobs & Marudas, 2009; Khanna, Posnett, & Sandler, 1995; Khanna & Sandler, 2000; Kitching, 2009; Marudas, 2004, 2015; Marudas & Jacobs, 2004; Okten & Weisbrod, 2000; Posnett & Sandler, 1989; Tinkelman, 1998, 1999, 2004; Tinkelman & Mankaney, 2007; Weisbrod & Dominguez, 1986). In addition, many public and private funders impose caps on overhead rates, restricting the ability of nonprofits to recover administrative and fundraising costs, while private individual donors appear to be similarly overhead-averse (Gneezy, Keenan, & Gneezy, 2014).

The resultant downward spiraling of overhead rates throughout the sector has contributed to a “nonprofit starvation cycle” that hampers the ability of nonprofits to fulfill their missions (Gregory & Howard, 2009; Lecy & Searing, 2015). Among “one of the best substantiated conclusions in nonprofit studies,” empirical research consistently contradicts the conventional wisdom that minimizing overhead improves organizational effectiveness (Lohmann, 2007, p. 441). Research instead confirms that low overhead reduces effectiveness (Gregory & Howard, 2009; Wing & Hager, 2004) and capacity (Chikoto & Neely, 2014; Lecy & Searing, 2015). Additional research has also associated overhead minimization with fundraising inefficiency (Young & Steinberg, 1995), reduced fiscal slack and reduced environmental resilience (Mitchell, 2016), underinvestment in administrative capacity (Gregory & Howard, 2009; Wing & Hager, 2004), increased financial vulnerability (Greenlee & Trussel, 2000; Tevel, Katz, & Brock, 2015; Trussel, 2002), and reduced utility (Burkhart, Wakolbinger, & Toyasaki, 2017). The harmful effects of fundraising ratio minimization norms include increased compliance and regulatory costs, misleading solicitations and misled donors, fundraising inefficiency, and inefficient charitable output provision (Steinberg & Morris, 2010).

The negative effects of low overhead on organizational effectiveness notwithstanding, the implications for nonprofit management are clear. Higher overhead invites reputational damage from information intermediaries and reduces contributions from donors. Indeed, mean overhead rates throughout the sector have fallen dramatically over time as nonprofit financial information has become more readily accessible (Lecy & Searing, 2015).

Perhaps no other proverb of nonprofit financial management is as well-subscribed as the proverb of overhead minimization (Lohmann, 2007). Yet overhead minimization introduces many unintended negative consequences and may perversely incentivize managers to sacrifice outcomes for low overhead because overhead is observed but outcomes are not (Mitchell, 2016).¹¹ This may be acceptable if the purpose of nonprofit management is to demonstrate trustworthiness through conformity to fiscal norms but is problematic if the purpose of nonprofit management is to efficiently achieve meaningful organizational outcomes.

Diversify Revenue

Prior research has traditionally confirmed many of the benefits of revenue diversification, including improved program outcomes in the arts (M. Kim, 2017), reduced resource dependence (Khieng & Dahles, 2015; Mitchell, 2012), reduced revenue volatility (Carroll & Stater, 2009; W. J. Mayer, Wang, Egginton, & Flint, 2014), reduced financial vulnerability (Chang & Tuckman, 1994, 1996; Froelich, 1999), and reduced risk of organizational demise (Hager, 2001). However, the impact on overall financial health is less conclusive (cf. Chang & Tuckman, 1996; Prentice, 2016) and subject to important contingencies that mediate and even reverse the desirable effects of diversification. For example, diversifying into private donations may increase financial volatility (Carroll & Stater, 2009) and may reduce expected revenue when substituted for earned income (W. J. Mayer et al., 2014). Further, nonprofits with more concentrated revenue sources report lower administrative and fundraising expenses, although these benefits increase exposure to revenue volatility (Frumkin & Keating, 2011).

The standard theory of the nonprofit developed by Hansmann and Weisbrod is implicitly modeled on the donative nonprofit based on its presumptions of contract failure and a separation between purchaser and recipient. For many stakeholders, donative revenue may be perceived as a more appropriate source of income than commercial revenue, but research suggests that donative revenue is less stable than commercial revenue, increasing financial vulnerability (Keating, Fischer, Gordon, & Greenlee, 2005). Thus, diversification into donative revenue may have negative unintended consequences.¹²

Diversification patterns within revenue categories have additional significant effects (M. Kim, 2017; Mitchell, 2012). For example, Chikoto, Ling, and Neely (2016) find that studies making use of highly aggregated Hirschman–Herfindahl indices (HHI) likely obscure the true significance and magnitude of the effects of diversification on various financial outcomes. They find that diversification does not reduce financial volatility for donative nonprofits, that increasing diversification within the earned income and investment income categories increases financial volatility, and that a previously observed positive relationship between revenue concentration and financial growth is even stronger when the HHI is disaggregated (Chikoto et al., 2016; Chikoto & Neely, 2014). Revenue concentration—not diversification—has been consistently associated with superior financial growth.

The benefits of revenue diversification may also be counterbalanced by the increased transaction costs associated with managing a greater number of revenue streams. de los Mozos, Duarte, and Ruiz (2016), for example, find that revenue diversification increases fundraising costs (the cost to raise US$1), especially for smaller nonprofits that tend to lack the administrative capacity to efficiently manage a diverse income portfolio.

Diversification strategies may be offered to nonprofits as a means of preserving or promoting fiscal health, particularly when other methods are unavailable. In many cases, fiscal volatility and vulnerability could be better managed by increasing fundraising, accumulating reserves, and issuing debt, but these strategies can be problematic for nonprofits, undermining their perceived trustworthiness.

In addition to being greatly overemphasized in the nonprofit financial management literature (M. Kim, 2017), revenue diversification does not appear to be universally sound advice for all nonprofits. Whether diversification is desirable depends on several factors, including the nature of a nonprofit’s benefits (Young, 2006), preexisting revenue models, risk–return tradeoff, and growth stage, among others. The effects of revenue diversification are complex and contingent, and may or may not be beneficial depending on an organization’s objectives and context.

Be Lean

If nonprofits are limited in their ability to accumulate sufficient operating reserves to cope with fiscal shocks, then managers may attempt to mitigate revenue volatility at its source through revenue diversification, and more generally, risk aversion. Nonprofits face pressure to immediately spend surplus revenues on current programs, lest they risk charges of “excessive” reserve accumulation. Indeed, in the aggregate, nonprofits do appear to value current spending over reserve accumulation (Calabrese, 2017), and many nonprofit CFOs admit that their organizations specifically aim to report zero annual profit (The Center on Philanthropy, 2012; Zeitlow, Hankin, & Seidner, 2007). As with overhead, reserve accumulation similarly appears to violate traditional sensibilities that equate fiscal leanness with organizational virtue and trustworthiness.

However, the benefits of strategic reserve accumulation are significant. Reserves can support program development and capital purchases and help organizations meet revenue gaps (Calabrese, 2017; Nonprofit Operating Reserves Initiative Working Group, 2008). Moreover, higher levels of reserves are associated with higher levels of financial stability (Tevel et al., 2015), and they allow nonprofits to more efficiently fundraise in sync with the business cycle—increasing fundraising and reserves during good times and decreasing both during difficult times (Lin & Wang, 2016; Mitchell, 2017).

Despite their benefits, many nonprofits find it difficult to accumulate reserves (Sloan, Grizzle, & Kim, 2015). Further-more, while many organizations claim to want increased reserves, significant numbers of nonprofits continue to operate with no reserves at all (Blackwood & Pollak, 2009; Calabrese, 2013). Perhaps because of such difficulties, many nonprofit managers rely instead upon lines of credit, capital reserves, and investments as substitutes for operating reserves to stabilize imbalances (Sloan, Charles, & Kim, 2016).

Nonprofits face many barriers to reserve accumulation. Many government contracts do not permit nonprofits to generate profits, and delayed contracts rarely reimburse nonprofits for the cash flow costs associated with the contract itself. The same can be applied to many private funders as well. Nonprofits operate in an environment that regards reserve accumulation as a diversion of resources away from current programs and a contravention of donor intent and charitable purpose that undermines organizational trustworthiness. For example, the Better Business Bureau–Wise Giving Alliance’s accreditation standards require nonprofits to “avoid accumulating funds that could be used for current program activities” (BBB Wise Giving Alliance, 2017), and the online information intermediary CharityWatch downgrades nonprofits with “excessive funds” that “hoard donations,” regardless of whether those funds are used to support future programs (CharityWatch, 2016b). Academic scholarship has similarly cautioned that “excessive” reserve accumulation may be “construed as indicative of commercial intent on the part of a nonprofit” (Tuckman & Chang, 1992). Nonprofit managers are, therefore, under pressure to create the appearance of high current program spending (Krishnan, Yetman, & Yetman, 2006) and low reserves to signal propriety and trustworthiness. Maintaining low or no reserves helps mitigate such risks of appearing “too wealthy” (Handy & Webb, 2003). Indeed, reserve accumulation can have negative reputational and financial effects for nonprofits. For example, Marudas (2004) and Calabrese (2011a) separately find that donations decline as net asset accumulation increases.

Managers have few viable alternatives to reserve accumulation. Tuckman and Chang (1991) identified overhead as a source of slack, because managers could reduce this rather than program spending during times of fiscal stress. But as intermediaries have increasingly relied on overhead rates to evaluate nonprofits, this source of slack has shrunk (Lecy & Searing, 2015). Nonprofits instead can attempt to reduce spending on nonoperating and non-revenue-generating activities during bad years, and reverse these decisions in good years (Eldenburg, Gunny, Hee, & Soderstrom, 2011). Empirically, however, nonprofits often respond to economic downturns with broad spending cuts and reductions in services—even despite the increased service demand that tends to accompany recessions. During the 2008-2009 Great Recession, for example, 59% of surveyed nonprofits experienced increased service demand, and 52% reported reduced funding (McLean & Brouwer, 2009). Organizations responded to this increased demand and reduced funding by cutting services (57%), freezing salaries (47%), freezing hiring (37%), laying off employees (30%), reducing employee benefits (20%), and reducing operating hours (13%). Similarly, a 2012 study identified spending reductions (82%), program reductions (63%), and personnel reductions (46%) as the most common tactics for coping with economic downturns (The Center on Philanthropy, 2012).

In addition, to maintain an appearance of fiscal leanness, nonprofits can allocate organizational growth efforts inefficiently over time by growing too slowly when fundraising is most remunerative and growing too quickly when fundraising is least remunerative—at the expense of higher total intertemporal fundraising costs (Mitchell, 2017). Finally, managers of nonprofits with defined benefit pension systems may alter pension contributions as needed—increasing them during good times and reducing them in bad times—effectively using the pension system as a revenue stabilization mechanism. This is hardly an exhaustive inventory of coping strategies for insufficient reserve accumulation but one that reveals a litany of negative unintended consequences deserving of greater attention. Ultimately, here and in other areas of nonprofit financial management, the often significant costs of maintaining organizational trustworthiness through proverb adherence are seldom accounted for (Mitchell, 2016).

Avoid Debt

Like overhead and reserve accumulation, debt service traditionally represents another diversion of resources away from current programs that can undermine a nonprofit’s reputation and trustworthiness. According to the online information intermediary Charity Navigator, for example, a nonprofit’s liability to asset ratio “helps donors understand if their donations are being used to service debt rather than servicing the charitable mission” (Charity Navigator, 2017). Nonprofits must maintain a ratio between 0% and 15% (depending on the subsector) to earn their highest rating. Indeed, prior research has found that both the debt service ratio (Charles, 2017) and high levels of indebtedness (Calabrese & Grizzle, 2012) are associated with reduced donations.

Such interpretations are “present-biased,” as nonprofits are pressured to fund current programs with current contributions, rather than previous costs with debt (Yetman, 2007) or future costs with accumulated reserves. Nonprofit management norms arbitrarily discount the value of past and future programming.

Debt aversion also has a legal basis in the U.S. context. When elite universities issued significant tax-exempt debt during the 1980s, public policy limited debt issuances for the entire sector from 1987 to 1997 (Calabrese & Ely, 2015). In this case, certain large nonprofits issued large amounts of tax-advantaged debt while also holding and increasing endowment assets. Policy makers became concerned that these endowments were not being immediately spent on current programs, and that benefits were accruing to these nonprofits at the expense of the federal treasury (Zimmerman, 2004). Policy makers wrote into law that debt was to be used sparingly, effectively validating the normative belief that debt for nonprofits is to be minimized or avoided altogether.

Concordant with this environment, nonprofits generally borrow very little. Zietlow et al. (2007), for example, found that more than 83% of nonprofits in 2000 reported no financial debt. This comports with data from 2003 when 79% of reporting nonprofits had no financial debt, defined as bonds, mortgages, or notes payable.¹³

However, debt has many advantages for nonprofits. Debt can capitalize an organization relatively quickly and at relatively low cost. Such capitalization can support programmatic expansion, and such expansion may attract additional revenues from expanded programs or newly attracted donors. New nonprofit organizations in particular may find that debt-financed capitalization permits them to focus more strongly on programs. Borrowing money—whether short-term (in the form of trade credit, notes, etc.) or long-term (in the form of mortgages, bonds, etc.)—is neither inherently a good nor a bad decision for any organization. Debt can fund new programs, support existing programs, save cash for other purposes, and secure needed capital for organizational growth (Bowman, 2002; Jegers, 2003; G. P. Smith, 2010).

Nonprofits in many cases need access to short-term borrowing as well. While nonprofits have used trade credit to maintain liquidity or to acquire capital (Bowman, 2002), this type of borrowing is expensive, especially relative to lines of credit and other more traditional short-term borrowings. Nonprofits that provide services contracted by governments frequently have cash flow mismatches between when services are provided (and resources are expended) and when payment from the government is received (and resources are received). Short-term borrowing can inexpensively and efficiently link these periods of time.

Because many nonprofits lack sufficient operating reserves to weather recessions and other exogenous shocks to their revenue streams (Calabrese, 2013), debt capacity represents an important (if imperfect) vehicle for maintaining program continuity during economic downturns. Making recourse to debt, rather than to spending cuts, can help organizations reduce staff turnover, maintain program capacity and scale, and cope with other sectoral norms that limit access to other forms of fiscal slack. Additionally, for capital expenditures, long-term debt is theoretically the most justifiable form of financing because it more closely links the costs and benefits of capital over long time periods. That is, current users of the capital asset do not bear all the costs of acquisition, and current assets (such as cash) are not immediately consumed (Calabrese, 2011b).

Alternatively, a nonprofit wishing to grow or make a large capital expenditure, but unwilling or unable to issue debt, could raise capital over a longer time period through donations. However, this would require accumulating surplus revenues, which is problematic for reasons already described. Expanding fundraising efforts is similarly problematic because increases in fundraising costs not offset by current program spending will increase overhead. Capital campaigns can take several years to raise sufficient money for a project and involve significant and immediate fundraising and managerial costs. Compared with debt issuances, capital campaigns may be less efficient in terms of cost and time, hindering organizational growth.

As a result, nonprofit managers find their strategic capital options substantially circumscribed. By limiting the availability of debt financing for organizations that already lack the ability to capitalize through sales of ownership equity, nonprofits have even fewer pathways available to support organizational growth and other strategic objectives. In addition, given the perpetual nature of most nonprofit organizations, coupled with the inevitability of economic fluctuations over time, the present-biasedness inherent in many proverbs of nonprofit financial management is problematic. It is principally with reference to organizational trustworthiness, not program continuity, growth, and impact, that the proverbs have coherence, with the sector operating under a presumption that norm deviation indicates fiscal impropriety, presumably in the form of nonprofit managers exploiting information asymmetries for personal gain.

Discussion

This somewhat unflattering and suspicious orientation toward the nonprofit perhaps finds its clearest articulation in Hansmann’s (1980) characterization of the nonprofit entity as a rational response to “contract failure.” Contract failure stems from the information asymmetry attendant to the separation between “purchasers” (donors) and “recipients” (beneficiaries) of program services. Because donors do not themselves receive program services (in the classical case), they are unable to adequately police “producers” (nonprofits) to ensure that their donated funds are being spent appropriately on services and not captured by nonprofit officers. In the for-profit scenario, company officers would face strong material incentives to capture net revenues for personal gain, contrary to donor intent. The “nondistribution constraint” eliminates, or at least makes more difficult, this possibility by prohibiting private inurement. So long as the nondistribution constraint is rigorously enforced, nonprofit organizations exhibit “trustworthiness.” Maintaining this trustworthiness remains a—if not the—principal emphasis of nonprofit financial management and accountability.

Adherence to “appropriate” sectoral norms or proverbs of nonprofit management is a means of signaling trustworthiness in the absence of credible information about outcomes.¹⁴ Indeed, the traditional proverbs of nonprofit financial management are collectively a reasonable response to the problems of (a) constraining self-interested profit-seeking, when altruism cannot be trusted and (b) encouraging thrift, when efficiency is not effectively incentivized, given that (c) nonprofit outcomes are unobservable. The proverbs are not, however, a particularly effective response to the problem of maximizing the production of organizational outcomes. The current accountability architecture governing nonprofit behavior through norm enforcement may be suitable for an “expressive” charitable ecosystem animated by warm-glow giving but not necessarily an “instrumental” ecosystem intended to achieve meaningful outcomes. This distinction may represent a scope condition for the standard theory of the nonprofit. The proliferation of alternative institutional forms to the 501(c)(3) public charity suggest that the traditional nonprofit entity, while perhaps delivering on trustworthiness, may not be in a particularly advantageous position to deliver efficiently on organizational outcomes.

A critical reexamination of the selected proverbs of nonprofit financial management raises crucial questions about (a) the soundness of nomothetic (as opposed to, for instance, contingent) management theory, (b) whether the realized benefits of proverb adherence demonstrably outweigh the negative unintended consequences, and (c) whether the nonprofit entity is fundamentally a vehicle for expressive almsgiving, an instrument for providing societal benefits, or something else—and depending on the case, whether the institutional form of the 501(c)(3) public charity is optimally designed and for what clearly specified intended purpose. Such fundamental ambiguities surely warrant greater attention.

Conclusion and Implications

For decades the field of public administration sought to identify nomothetic principles that would provide general management guidance for practitioners across contexts. After years of critical reflection, these efforts have largely been abandoned in favor of contingency models and other theories that take greater account of context. Yet within the nonprofit financial management literature, relatively rigid proverbs still actively govern the practice of nonprofit management. These proverbs cohere with a very specific conception of the nonprofit entity—the “standard theory”—as developed by Hansmann and Weisbrod, which articulates a paradigm for nonprofit management that emphasizes the demonstration of organizational “trustworthiness” under an assumption of outcome unobservability. As a matter of institutional design, the nonprofit entity’s primary feature is the mitigation of the risk that nonprofit officers will exploit information asymmetry for personal gain. Accordingly, organizational surveillance focuses on discovering, and managerial attention focuses on avoiding, appearances of resource diversion and inappropriate risk-taking. Resource diversion is conventionally operationalized in terms of “excessive” overhead, reserve accumulation, and debt service, while inappropriate risk-taking may involve revenue concentration and high debt ratios.

However, this paradigm of surveillance and management produces a multitude of negative unintended consequences that divert attention from, and in many circumstances, may inhibit, the efficient attainment of program outcomes. Indeed, none of the principal management imperatives implied by the standard theory should be expected to optimally yield such outcomes. If the purpose of the nonprofit entity is to produce meaningful societal benefits or to materially address or solve social problems given scarce resources, then it is far from obvious that the public charity is optimally designed. This raises an additional question about the generalizability of established nomothetic nonprofit management theory, which although predicated on assumptions that cohere more with the expressive than with the instrumental dimension of philanthropy, nevertheless demands universal conformity to relatively fixed norms or “proverbs.” This conformity to the norms of expressive philanthropy is vigorously enforced through an accountability architecture largely fixated on financial benchmarks to the exclusion of outcomes.

Future scholarship should continue to address these issues, particularly those pertaining to nomothetic management theory and the unintended negative consequences of its proverbs, as well as ambiguities related to institutional purpose. Specifically, scholars should more thoroughly reconsider the theoretical basis for, consequences of, and contingent nature of, nonprofit financial management practices. Likewise, stakeholders that enforce proverbs of nonprofit financial management through ratings, rankings, designations, regulations, and policies should consider whether their particular forms of surveillance are consistent with their presumed objective of efficient resource allocation.

Nonprofit practitioners also should reflect on their own assumptions and practices, and discuss with their stakeholders whether or to what extent adherence to managerial proverbs constrains their organizations’ abilities to efficiently achieve meaningful outcomes. In many circumstances, donors, board members, external stakeholders, and even organizational managers and leaders themselves may not be aware that practices such as minimizing overhead, diversifying revenues, and avoiding reserve accumulation and debt may be substantially inhibiting organizational efficiency, effectiveness, and the attainment of other strategic objectives.

Finally, educators should be careful to not uncritically perpetuate proverbs of nonprofit financial management. Management courses should explicitly identify the negative unintended consequences of proverb adherence and problematize the underlying management theory. More specifically, students should be asked to consider the extents to which the purpose of nonprofit financial management is to demonstrate organizational trustworthiness or to maximize the attainment of other strategic objectives, such as maximizing program impact, and how managers should balance these imperatives when they conflict.

Footnotes

Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author(s) received no financial support for the research, authorship, and/or publication of this article.

Notes

Author Biographies

George E. Mitchell is an associate professor at the Marxe School of Public and International Affairs at Baruch College. Before joining the Marxe School, he was an assistant professor at the Colin Powell School at the City College of New York, was a founding Member of the Transnational NGO Initiative at the Maxwell School of Syracuse University, and worked in the post-conflict reconstruction sector in the Middle East. His research examines topics in NGO and nonprofit management, leadership, and strategy, and appears in journals of NGO and nonprofit studies, public administration, and international relations.

Thad D. Calabrese teaches and researches in the field of public and nonprofit financial management. He is especially interested in the areas of employee benefits, the financial implications of collaborative governance and contracting, and capital structure decisions in public service organizations.

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