Nonprofit Sector: Treatment and Reimbursement of Indirect Costs Vary among Grants, and Depend Significantly on Federal, State, and Local Government Practices
Published: 2010-05-18T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Nonprofits are key partners in delivering federal services yet reportedly often struggle to cover their indirect costs (costs not readily identifiable with particular programs or projects). This raises concerns about fiscal strain on the sector. To provide information on nonprofits' indirect cost reimbursement, especially when funding flows through entities such as state and local governments, GAO was asked to review, for selected grants and nonprofits, (1) how indirect cost terminology and classification vary, (2) how indirect costs are reimbursed, and (3) if gaps occur between indirect costs incurred and reimbursed, steps taken to bridge gaps. GAO selected six Departments of Health and Human Services and Housing and Urban Development grants and 17 nonprofits in Louisiana, Maryland, and Wisconsin. GAO selected these agencies for their historical relationship with nonprofits. GAO reviewed policies and documents governing indirect costs and interviewed relevant officials. GAO also reviewed research on nonprofits' indirect costs.
section_title: What GAO Found
paragraphs: Depending on the grant program, nonprofits may be reimbursed for indirect costs (generally costs such as rent or utilities), administrative costs (generally cost activities such as accounting or personnel), both, or neither. OMB officials said costs can be classified as either indirect or direct, and administrative cost activities are usually, but not always, classified as indirect costs. However, inconsistencies in the use and meaning of the terms indirect and administrative, and their relationship to each other, has made it difficult for state and local governments and nonprofits to classify costs consistently. This has resulted in varying interpretations of what activity costs are indirect versus administrative. As OMB guidance on cost principles for nonprofits recognizes (2 CFR Part 230), because nonprofit organizations have diverse characteristics and accounting practices, it is not possible to specify the types of costs that may be classified as indirect in all situations. This increases the challenges of administering federal grants and, in some cases, makes it difficult for recipients to determine those activities eligible for indirect cost reimbursement under a particular federal grant and those that are not. GAO found differences in the rate in which state and local governments reimburse nonprofits for indirect costs. These differences, including whether nonprofits are reimbursed at all, largely depend on the policies and practices of the state and local governments that award federal funds to nonprofits. Federal grants often provide wide latitude in setting cost reimbursement policies and practices, and some state and local governments do not reimburse these costs at all. Those that do can often choose the reimbursement rate. As a result, GAO found that variations in indirect cost reimbursement exist not only among different grants, but also within the same grant across different states. GAO found that nonprofits fund indirect costs with a variety of federal and nonfederal funding sources, and that when indirect cost reimbursement is less than the amount of indirect costs nonprofits determine they have incurred, most nonprofits GAO interviewed take steps to bridge the gap. They may reduce the population served or the scope of services offered, and may forgo or delay physical infrastructure and technology improvements and staffing needs. Because many nonprofits view cuts in clients served or services offered as unpalatable, they reported that they often compromise vital "back-office" functions, which over time can affect their ability to meet their missions. Further, nonprofits' strained resources limit their ability to build a financial safety net, which can create a precarious financial situation for them. Absent a sufficient safety net, nonprofits that experience delays in receiving their federal funding may be inhibited in their ability to bridge funding gaps. When funding is delayed, some nonprofits said they either borrow funds on a line of credit or use cash reserves to provide services and pay bills until their grant awards are received. Collectively, these issues place stress on the nonprofit sector, diminishing its ability to continue to effectively partner with the federal government to provide services to vulnerable populations.

section_title: Letter
paragraphs: Nonprofit organizations have increasingly become key partners with the  federal government in delivering important federal services throughout the  nation, including health care, education, housing, and human services. One  study estimates that nonprofits received approximately $317 billion from  the federal government in fiscal year 2004 for service delivery. The  Congressional Research Service (CRS) estimates that government grants  and payments to the nonprofit sector increased almost 53 percent from  1995 to 2005, demonstrating governments’ increased reliance on this  sector to deliver public services. The breadth and diversity of nonprofits  allow them to tailor services to the specific needs of communities and  individuals. However, funding is often limited for the indirect costs  associated with providing these services (indirect costs are generally costs  such as rent or utilities that cannot be readily identified with a particular  service or product). Sometimes costs that would normally be classified as  indirect costs are covered in other ways; other times they are not covered  at all. As such, we have reported that nonprofits often struggle to cover the  costs of doing business, which raises concerns about the long-term  financial health and durability of the sector and its ability to effectively  deliver federal services and programs.
Congress recently took steps toward addressing these challenges. For  example, the Serve America Act increases the limit on nonprofits’ use of  program funds for administrative costs from 5 to 6 percent for some  federal education grant programs, and the American Recovery and  Reinvestment Act of 2009 (Recovery Act) makes $50 million available  through the Department of Health and Human Services’ Strengthening  Communities Fund to help build the capacity of nonprofit organizations.  Further, if enacted, the Nonprofit Capacity Building Act of 2009 would  establish a nonprofit capacity-building program to award grants for  organizational development assistance to small and midsize nonprofit  organizations facing resource hardship challenges.
Our prior work identified the need for more information on various  aspects of the federal-nonprofit relationship, particularly funding received  from federal sources. Responding to your request for more information on  indirect cost reimbursement, especially when federal funding is passed  through to nonprofits from other entities such as state and local  governments, we reviewed, for selected federal grant programs and  nonprofits, (1) how indirect cost terminology and classification vary,   (2) how indirect costs are reimbursed, and (3) if gaps occur between  indirect costs incurred and reimbursed, steps nonprofits take to bridge the  gaps.
To achieve our objectives, we selected six federal social services and  housing grants from two federal agencies: the Department of Health and  Human Services (HHS) and the Department of Housing and Urban  Development (HUD). We selected HHS and HUD as our two primary  agencies of focus because of their familiarity and historical relationship  with nonprofit organizations. Within these agencies, we selected grants  based on their design to fulfill a range of housing and social service needs.  The selected grants are    Promoting Safe and Stable Families (PSSF) grant and Family Violence  Prevention and Services/Grants for Battered Women’s Shelters  administered by HHS’s Administration for Children and Families (ACF),    Block Grants for Community Mental Health Services and Block Grants for  Prevention and Treatment of Substance Abuse administered by HHS’s  Substance Abuse and Mental Health Services Administration (SAMHSA),  and    Emergency Shelter Grants (ESG) and Housing Opportunities for Persons  with AIDS Grant (HOPWA) administered by HUD’s Office of Community  Planning and Development (CPD).
We reviewed federal statutes for the six grants we studied, as well as  Office of Management and Budget (OMB), HHS, and HUD documents,  guidance, and policies governing the treatment of indirect costs. We also  interviewed budget and program officials at these agencies. We selected  three states—Louisiana, Maryland, and Wisconsin—and more than 20  local government and nonprofit organizations to which these states award  federal funding under some or all of the six grants. These states and  nonprofits were selected based on criteria such as amount of HHS and  HUD funding received, population, and geographic dispersion. We  reviewed documents, guidance, and policies governing the treatment of  indirect costs from these states, local governments, and nonprofits, and  interviewed budget and program officials in these organizations. Further,  we interviewed officials from nonprofit associations, such as the National  Council of Nonprofits and the Nonprofit Finance Fund. We also conducted  a literature review of research on nonprofits’ indirect costs, and  determined that the studies we included in our work are methodologically  sound. This research is referenced throughout our report, where  applicable.
We conducted this performance audit from October 2008 to May 2010 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives. Although the illustrative examples in this  review cannot be generalized to all federal grant programs, state and local  governments, or nonprofit organizations, we believe they provide valuable  insight into the challenges of indirect cost classification and the funding  relationship between the federal government and the nonprofit sector.  Appendix I contains more details on our scope and methodology.
subsections: section_title: Background
paragraphs: Federal grants are forms of financial assistance from the government to a  recipient for a particular public purpose that is authorized by law. Federal  grant funds flow to the nonprofit sector in various ways, as shown in  figure 1. Some grant funds are awarded directly to nonprofits, while others  are first awarded to states, local governments, or other entities and then  awarded to nonprofit service providers. Federal laws, policies,  regulations, and guidance associated with federal grants apply regardless  of how federal grant funding reaches the final recipients.
Some federal grant programs contain statutory limits on administrative  cost reimbursement for state and local government grantees. Additionally,  some federal grant programs predetermine a limit for subgrantees (see  table 1 for the statutory limits on the six grants we reviewed).
OMB circulars A-87 and A-122 provide guidance to state and local  governments and nonprofits on classifying costs as direct or indirect and  direct state and local governments to employ the necessary management  techniques in order to efficiently and effectively administer federal  awards. OMB circulars A-87 and A-122 generally define direct and indirect  costs as follows:    Direct costs are those that can be identified specifically with a particular  final cost objective, that is, a particular award, project, service, or other  direct activity of an organization.
Indirect costs are those that have been incurred for common or joint  objectives and are not readily assignable to the cost objectives specifically  benefited, without effort disproportionate to the results received. A cost  may not be allocated to an award as an indirect cost if any other cost  incurred for the same purpose, in like circumstances, has been assigned to  an award as a direct cost. Direct costs of minor amounts may be treated as  indirect costs under certain conditions. Recognizing that nonprofit  organizations have diverse characteristics and accounting practices, the  guidance states that it is not possible to specify the types of cost that may  be classified as indirect costs in all situations. Whether a nonprofit  classifies costs as direct or indirect is often a result of the organization’s  ability to link costs to a particular program.
OMB Circular A-122 guidance to nonprofits further divides indirect costs  into two broad categories: facilities and administration.
Facilities costs generally include costs related to the “depreciation and use  allowances on buildings and equipment, as well as operations and  maintenance expenses.”
Administration costs generally include “general administration and  expenses such as the director’s office, accounting, personnel, library  services and all other expenses not listed under facilities.”
OMB Circular A-133 provides general guidance on the roles and  responsibilities of the federal awarding agencies and primary recipients of  government funds regarding audit requirements of grantees. It sets forth  standards for obtaining consistency and uniformity among federal  agencies for the audit of states, local governments, and nonprofit  organizations expending federal awards totaling $500,000 or more  annually. Among other responsibilities, it gives  federal awarding agencies the responsibility to advise recipients of  requirements imposed on them by federal laws, regulations, and the  provisions of contracts or grants and    primary recipients the responsibility to identify grant awards; advise  subrecipients of requirements imposed on them by federal laws,  regulations, and the provisions of contracts or grant agreements as well as  any supplemental requirements; and monitor the implementation of the  grants.
Awarding agencies and all recipients and subrecipients of federal grant  funds must comply with certain data collection, record-keeping, and  reporting requirements to help monitor grant implementation. These  requirements differ across grants and are determined by the federal  awarding agency, federal law, or both. State and local governments  sometimes impose additional requirements on their subgrantees.
section_title: Inconsistencies in Terminology Lead to Challenges in Cost Classification, Which Can Result in Uneven Treatment of Costs
paragraphs: Understanding OMB guidance regarding the relationship between indirect  and administrative costs is particularly challenging for state and local  governments and nonprofits. According to OMB officials, the terms  “direct” and “indirect” can be thought of as ways to classify costs; that is,  they are “cost buckets.” In contrast, the term “administrative” refers to a  cost function or activity—such as accounting, procurement, personnel, or  budgeting. On the one hand, OMB Circular A-122 cost guidance to  nonprofits indicates that administrative costs are usually but not always  indirect costs; on the other hand, that same guidance lists “administration”  costs as one of two categories of indirect costs. Further, OMB Circular A- 87 cost guidance to state and local governments uses the terms indirect  and administrative interchangeably in certain places. Taken together, the  OMB guidance can be viewed as ambiguous. Guidance is most useful  when it is clear and well understood. OMB officials told us that given the  uncertainty and confusion with respect to these definitions and their  application, it may be helpful to bring federal, state, and local officials  together with representatives from nonprofit organizations to discuss  these issues. Doing so, they acknowledge, could help clarify and improve  understanding of how indirect costs should be treated.
Classifying similar costs differently can make it difficult to determine how  much money grantees receive for cost activities typically thought of as  indirect, and at what rate. For example, the ESG program provides states  or local government grantees up to 5 percent for administrative costs. As  the primary recipients of ESG funds, states are required to share at least a  portion of this funding with local government subgrantees; however, there  is no such requirement for cost sharing with nonprofits. Thus, on its face it  may appear as if ESG provides no administrative cost reimbursement for  nonprofits. However, the ESG statute allows some emergency shelter  costs, such as rent and utilities, which are typically thought of as indirect  costs, to be claimed as a direct cost under ESG’s “operating costs”  activity—one of five direct program activities for which subgrantees may  be reimbursed. In another example, the statute for the HOPWA grant  program limits administrative cost reimbursement for project sponsors to  7 percent. Because administrative costs can either be charged as direct or  indirect costs depending on the circumstance, and because HOPWA has  no explicit limit on indirect costs, it is difficult to accurately characterize  cost reimbursement for activities commonly thought of as indirect.
When grants and grantees classify similar costs differently it can also  result in the same cost activity being covered for some nonprofits but not  others, and can increase the complexity of administering the grants.  Nonprofit association officials told us that because grant award packages  and federal guidance contain unclear or conflicting information on how to  allocate costs, nonprofits sometimes unknowingly exclude eligible  expenses in their calculation of administrative costs and, as a result, limit  their own reimbursement potential. Further, some of the nonprofit and  association officials we spoke with said that because grant programs have  different definitions of indirect costs, they must take care to reconcile  their own accounting systems with the requirements of each grant they  receive to ensure that they properly account for the funds. They also said  that this is time consuming and resource intensive, and that more  consistent classifications and treatment across federal grants would  simplify grant administration and may reduce costs.
We and others have previously reported that federal grant programs  sometimes classify similar or identical costs differently. In 2006, we  reviewed seven programs from HHS, and the Departments of Agriculture  and Labor, and found that the legal definitions of and the federal funding  rules for administrative costs varied even though many of the same  activities were performed to administer the programs. The report noted  that the statutes and regulations that define administrative costs for these  programs differ in part because the programs evolved separately over time  and have different missions, priorities, services, and clients. Further, the  report noted that a number of state budget officials said that varying  definitions of administrative costs create challenges for them. For  example, one said that it can be difficult to develop coding for accounting  and budgeting that can be used across programs and, as a result, it can be  difficult to monitor costs accurately; another shared this concern and said  that consistent definitions of and caps for administrative costs would  make it easier to allocate costs across programs and, therefore, might  reduce costs. This concern is not new; in a 2002 report on tax-exempt  organizations, we reported that different approaches for charging  expenses, as well as different allocation methods, can result in charities  with similar types of expenses allocating them differently.
Even though the terms indirect costs and administrative costs are not  synonymous, we found that some nonprofit, state, and local government  officials we spoke with use them interchangeably. A national nonprofit  association official made a similar observation, noting that terminology  varies throughout the nonprofit sector. State and local government and  nonprofit officials we spoke with also reported using other terms, such as  overhead, general operating expenses, or management and general  expenses, synonymously with indirect and administrative costs.
A 2007 report on nonprofits’ overhead costs also discussed widespread  confusion about indirect costs throughout the sector, and identified  “variations in definitions of overhead and the overhead cost rate” as areas  of concern among nonprofit researchers and practitioners. The report  also concluded that there is a substantial difference between indirect costs  and administrative costs, noting that not all indirect costs are  administrative, such as the costs of a telemarketing campaign, which is a  programmatic or fundraising function. The report also said that there are  administrative costs that are direct costs, such as those for the computers  and office supplies used by the finance department.
Inconsistencies in guidance in grant award packages and across federal  programs add to the challenge of administering federal grants. For  example, officials from a Louisiana nonprofit said that one federal  contract may allow them to charge rent as a direct cost, while another  federal contract states that it is to be charged as an indirect cost. These  officials told us that they should be able to “call an apple, an apple….every  time.” In another example, HUD’s supplemental guidance for HOPWA  recipients advises that in reviewing administrative and indirect costs,  recipients should keep in mind that “all administrative costs are indirect  costs, but not all indirect costs are administrative costs.” Conversely, in  describing HHS’s PSSF grant and the Family Violence Prevention  Services/Battered Women’s Shelter grant, ACF officials explained that  administrative costs can be either direct or indirect costs.
section_title: Nonprofits’ Reimbursement for Indirect Costs Largely Depends on Federal, State, and Local Government Practices
paragraphs: For the majority of grants in our review, we found that state and local  government grantees are allowed to decide whether or not and how much  they reimburse nonprofit subgrantees for their administrative or indirect  costs. In all three states we reviewed, we found differences in the rates at  which state and local governments reimburse nonprofits for indirect costs.  These differences, including whether nonprofits are reimbursed at all,  largely depend on the policies and practices of the state and local  governments that award federal funds to nonprofits. State and local  governments may apply the same indirect cost limit to all subgrantees or  may choose to apply different indirect cost limits to different subgrantees.  For example, for all subgrantees who receive funds under the Block  Grants for Community Mental Health Services and the Prevention and  Treatment of Substance Abuse, the Louisiana Department of Health and  Hospitals limits indirect cost reimbursement to 12 percent. Other state and  local government agencies, such as the Wisconsin Department of Health  Services, work with individual subgrantees to determine an indirect cost  reimbursement rate. Officials from the department told us that they often  assist subgrantees in determining how to classify costs; this helps to  determine what costs to reimburse as indirect, and at what rate.
The amount of funding passed through to nonprofits can also be affected  by the amount of funding a state or local government uses for its own  administrative costs. For example, according to a Dane County, Wisconsin  official, Dane County receives 10 percent for administrative and indirect  costs for the PSSF grant from the state of Wisconsin and passes the entire  amount on to its nonprofit service providers; this increases the amount of  funds available to nonprofits. However, some state and local governments  we spoke with interpret statutory limitations on their own administrative  costs as necessarily limiting the administrative and indirect costs  allowable by the grant for all subgrantees. Although states often enjoy  wide latitude in determining the administrative and indirect  reimbursement rates of their subgrantees, applying a more specific  interpretation of federal statute potentially limits the amount of funds  available to nonprofits.
Variations in cost coverage exist not only among different grants across  different states, but also within the same grant across different states. For  example, for the PSSF grant, states may retain up to 10 percent of the  grant award to pay for their own costs to administer this grant, or they  may pass this amount through to the nonprofit service providers to which  they award PSSF grants. In addition, states may determine the allowable  level of indirect cost reimbursement for the nonprofit service providers to  whom they award PSSF grants. As shown in figure 2, three nonprofits that  receive funding under the PSSF grant in Louisiana, Maryland, and  Wisconsin are reimbursed for their indirect costs, administrative costs, or  both at different rates (9.4 percent, 0 percent, and 14 percent,  respectively).
The differences among reimbursement rates for these nonprofits may in  part be due to the presence or absence of an indirect cost rate agreement.  Primary recipients of federal funds are required to have a federal indirect  cost rate agreement in order to be reimbursed for indirect costs. There is  no such requirement for recipients that receive federal funds that first flow  through entities such as state and local governments. Five of the 17  nonprofits in our sample have federal agreements. However, state and  local governments are not required to consider or honor federal indirect  cost rate agreements when awarding federal funds. Some state and local  governments negotiate a similar indirect cost rate agreement directly with  subrecipients; others do not.
section_title: When Nonprofits Report Differences between Indirect Costs Incurred and Reimbursed, They Take a Variety of Steps to Bridge Gaps
subsections: section_title: Nonprofits Fund Indirect Costs from a Variety of Sources
paragraphs: To help cover their indirect costs, nonprofits reported using funding from  a variety of sources in addition to federal funds, such as capacity-building  grants, private donations, fundraising, endowment funds, and business  income generated from services provided. For example, some of the  nonprofits we spoke with operate fee-for-service furniture restoration,  repair shop, and batterers’ treatment programs. A Wisconsin nonprofit  official said that the United Way recognizes the challenges nonprofits face  in receiving reimbursement for indirect costs and provides unrestricted  funding to help cover them. Other nonprofit officials we spoke with,  however, reported that these grants can be difficult to secure. A November  2009 CRS report noted, perhaps not surprisingly, that charitable giving  declined during the recent recession. For some nonprofits the decline  comes at a time when their services may be in greater demand, which can  further strain resources.
Nonprofits also rely on in-kind donations and volunteer labor to help cover  costs. For example, nonprofits reported receiving food donations from  local restaurants, furniture donations, and facilities repairs by nonprofit  board members. One Louisiana nonprofit official said that in-kind and  volunteer labor is essential for her organization’s ability to provide  services, and it received $160,000 in volunteer labor in 2008. However,  nonprofit officials also noted that while the use of volunteer labor is  valued, it is not “free,” as volunteers may require additional supervision  and training.
section_title: Nonprofits Take Steps to Bridge Reported Funding Gaps
paragraphs: Fifteen of the 17 nonprofits in our sample reported that funding received  for indirect costs does not cover their actual indirect costs. A nonprofit  official whose organization receives a HUD grant from the state of  Wisconsin said that his organization is authorized to claim 5 percent for  administrative costs associated with delivering supportive housing  program services, but that amount does not cover the costs of  administering the program. In another example, recipients of the Family  Violence Prevention Services/Grants for Battered Women’s Shelters grants  in all three states reported receiving no indirect cost reimbursement, but  their overall organizational indirect costs ranged from about 8 to 11  percent. Similarly, nonprofit subrecipients of ESG funding across all  three states reported no indirect cost reimbursement from state and local  governments. The overall organizational indirect costs for these nonprofits  ranged from 1.8 to 20 percent. These self-reported levels are generally in  line with an Urban Institute study that analyzed the 1999 tax returns of  approximately 160,000 health-related and human services nonprofits, and  reported average management and general expenses of 17 and 16 percent,  respectively.
Although nonprofits’ fiscal challenges are not limited to indirect cost  funding, as noted above, funding sources that can be used to cover  indirect costs can be difficult to come by. As such, it is particularly  important to understand steps nonprofits take to bridge gaps when they  report gaps between indirect costs incurred and reimbursed. We found  that nonprofits often respond by reducing service levels, compromising  infrastructure and staff investments, or both, and that these cost-cutting  measures can limit nonprofits’ ability to build a financial safety net.
subsections: section_title: Reduced Service Levels
paragraphs: Several nonprofits we spoke with said at the time of our interviews they  had reduced the size of their programs and populations served as a result  of gaps in funding for direct and indirect costs. For example, a Louisiana  nonprofit official said that his organization scaled back its housing and  shelter services 10 to 15 percent even though its mission is to serve all at- risk youth in need of these services. As a result, he said, the nonprofit now  has a waiting list for its residential services. A Maryland nonprofit official  told us that the organization’s psychiatric rehabilitation program was one  of the largest in the state. However, according to this official, the level of  reimbursement his organization received from government sources led to  the nonprofit reducing the program’s size in order to remain viable. A 2008  study that examined several nonprofits also discussed negative effects on  nonprofits’ capacity to provide services due to funding gaps, noting that as  a result of funding gaps in the short term, staff members struggle to  provide more services but with fewer resources.
Nonprofits we spoke with also reported reducing the range of services  they offered. An official from a Maryland nonprofit whose mission  includes providing housing, employment services, and job referrals, said  that the organization once provided a computer lab with a part-time  computer instructor for its clients as part of its General Education  Development services. The official said that in an effort to more closely  align costs incurred with costs reimbursed, the nonprofit eliminated the  instructor position because it was not directly related to the organization’s  primary mission of providing supportive housing and housing placement.  Officials from a Maryland drug and alcohol rehabilitation nonprofit told us  that they discontinued a vocational education program for similar reasons.
section_title: Compromised Infrastructure Investments
paragraphs: Many nonprofits compromise vital facilities maintenance and “back-office”  support functions, such as information technology systems, to avoid  reducing their services. Almost half of the nonprofits we spoke with  reported making such trade-offs. For example, a Louisiana nonprofit said  that it does not have an updated security system that adequately protects  the victims of domestic violence that it serves, which directly affects the  nonprofit’s ability to fulfill its mission—providing a safe space for victims  of domestic violence. We also observed ceilings that were in disrepair  when we toured this nonprofit’s facility. An official from a Maryland  nonprofit said that her staff makes personal sacrifices to sustain services,  such as working in dark offices to conserve electricity costs or bringing  supplies from home. Wisconsin nonprofit officials reported that their  medical and dental appointment systems are not integrated, inhibiting  their ability to better serve their patients.
The experiences of these nonprofits are consistent with other studies’  findings that trade-offs in facility maintenance can hinder nonprofits’  ability to effectively carry out their mission in the long term. A 2007 study  on the financial health of the human service providers in Massachusetts  said that providers may defer routine costs, such as facility maintenance  and other critical infrastructure investments, when they lack indirect cost  funding. A 2008 study suggested that funders have unrealistic  expectations for nonprofits’ indirect costs, which can lead nonprofits to  underinvest in infrastructure that is needed to maintain or improve  standards for service delivery. A 2008 study on the administrative  management capacity of 16 select nonprofit programs noted that many  organizations cite a lack of resources for information technology  infrastructure needs and that some organizations in the study reported  that they cannot meet technology needs beyond a basic level of  functionality. The study also reported that these organizations lack  sufficient strategic and long-term planning for future information  technology needs and equipment and software updates.
section_title: Compromised Staff Investments
paragraphs: Nonprofits often report that they forgo staff investments or reduce or  freeze salaries to avoid reducing services. Officials from 10 of 17  nonprofits we spoke with said that at the time of our interviews they had  delayed filling vacant positions or have eliminated positions to cover  costs. For example, officials from a Maryland nonprofit eliminated a  development position and trained a receptionist to assume other  responsibilities. As a result, the organization lacked a dedicated  receptionist during business hours, which makes it more challenging to  respond to clients’ needs. A Wisconsin nonprofit said that it has not hired  a medical coder—a position that would allow the doctors in the  organization to devote more time to seeing patients instead of on  administrative paperwork. Another Wisconsin nonprofit official reported  instituting a voluntary leave without pay program during the summer  months to reduce salary costs. Another Maryland nonprofit official  explained that because she cannot attract qualified staff at the salary she is  able to offer, she usually hires people with very little experience who  require a significant amount of training and supervision. Similarly, officials  from a third Maryland nonprofit said that they are unable to provide salary  increases or cost-of-living adjustments for their staff and have had to cut  benefits.
Other studies have shown that nonprofits may also leave positions vacant  to realize savings, which can have adverse quality implications. A 2008  study found that program staff at the 16 nonprofits in the study often take  on administrative tasks, such as recruitment processes and site  maintenance, to bridge gaps in administrative infrastructure and support;  as a result, program staff devote less time to activities more directly tied to  service delivery and quality programming. A 2004 study on nonprofit  overhead costs reported that limited or no staff for administrative  functions limited nonprofits’ ability to manage and monitor finance,  development, and other important functions. A 2007 study noted that  staff salaries and benefits of the human service providers in Massachusetts  do not appear to keep pace with increases in the overall cost of living. It  further noted that the relatively low wages can limit the qualifications and  level of experience of many direct care workers and can lead to rapid staff  turnover.  A 2004 study on nonprofit overhead costs discussed how  challenges in recruiting and retaining qualified staff compromised  nonprofits’ effectiveness, noting that key positions are filled by individuals  with little relevant experience and training, and once staff gain relevant  experience, they seek employment at organizations with higher salaries,  leading to high turnover for nonprofits.
section_title: Limited Ability to Build a Financial Safety Net
paragraphs: Nonprofits’ strained resources also limit their ability to build financial  reserves for unanticipated expenses. Officials at a Louisiana nonprofit said  that their ability to build a financial safety net is limited because they  struggle to cover their costs and do not have money left over to save. A  nonprofit association official said that nonprofits sometimes cannot set  aside sufficient cash reserves to cover unforeseen costs, such as a broken  boiler. To address unexpected costs, nonprofits often draw from their  program costs where possible, which can lead to a decline in program  quality. Other studies also reported on financial sustainability challenges  for nonprofits. Nonprofit financial management experts have  recommended that nonprofits maintain cash reserves sufficient to fund 3  months of operating expenses. A 2009 study on the operating reserves of  over 2,000 Washington, D.C. area nonprofits reported that in 2006, 57  percent of the operating public charities in the Greater Washington area  had operating reserves of less than 3 months; 28 percent of these  organizations reported no operating reserves. A 2008 study on the  administrative management capacity of select nonprofit programs  reported that half of the nonprofits in the study do not maintain the  recommended level of reserves. Finally, a 2007 study reported that one- third of the more than 600 Massachusetts providers in its sample had less  than 15 days’ cash at the ends of their fiscal years; another quarter have  only 3 to 4 weeks of cash at the ends of their fiscal years. Given recent  economic conditions, the need for sufficient cash reserves may be  particularly important.
section_title: Untimely Reimbursements and High Grant Administration Costs Exacerbate Nonprofits’ Reported Funding Gaps
paragraphs: A November 2009 CRS report noted that (1) in addition to funding cuts,  states apparently have been delaying payments for services they have  contracted with nonprofits to provide; and that (2) it appears that  governments, particularly state governments, may be contributing to the  financial difficulties of nonprofit organizations. During the course of our  work, we spoke with nonprofits that made similar observations. Factors  such as untimely reimbursements and high grant administration costs can  place stress on the nonprofit sector, diminishing its ability to continue to  provide services to vulnerable populations. OMB officials acknowledged  that building nonprofits’ capacity to manage may help nonprofits better  contend with these issues and continue to meet their missions.
subsections: section_title: Untimely Reimbursements
paragraphs: Untimely receipt of government grant and contract payments contributes  to financial strain on nonprofits. Six of the 17 nonprofits in our study  reported that their reimbursements from federal, state, and local  governments are delayed at times, which can cause cash flow problems  and undermine their sustainability. For example, an official from a  Maryland nonprofit said that her organization was awarded an HHS grant  from the state of Maryland in October 2008 but did not actually receive the  funding until May 2009. Maryland nonprofit officials said they sometimes  experience 15- to 30-day delays in reimbursement from the state of  Maryland. One Maryland nonprofit official said delays such as these create  a “cash-flow nightmare” for her organization. The nonprofit has a line of  credit it can draw on to tide it over until it receives grant payments, but  this increases costs because it incurs interest and fees on the line of credit,  which are not reimbursed. Three of the nonprofits in our study said that  smaller nonprofits without cash reserves or lines of credit rely on timely  payments to sustain their operations. They said that even small delays put  these nonprofits at risk of failure. Some state and nonprofit association  officials we spoke with, however, said that reimbursement delays also  occur when nonprofit staff are so busy operating programs that they do  not keep up with filing invoices in a timely manner; as a result, when  nonprofits most need the money, it is not available.
We and others have also cited challenges nonprofits face as a result of  delayed reimbursements from federal, state, or local governments. In 2006  we reported that recipients of selected federal grants reported that  delayed awards create significant burden on them and limit their ability to  plan for and efficiently execute grant programs. Grant recipients noted  that they often received award notifications significantly later than they  had anticipated, sometimes months after the expected award date  provided in the opportunity announcement. These uncertainties and  delays caused significant problems in planning for and executing grant  projects. Grant recipients in this study suggested that agencies should  award grants in a more timely way or provide more precise information on  when an award could be expected. A 2007 study on the financial health of  the human service providers in Massachusetts noted that when an  organization with limited cash experiences unexpected delays in the  receipt of income, a crisis situation can occur. A 2002 study that reviewed  prior research on this topic noted that when government agencies are  delayed in approving contracts or grant payments, recipient organizations  often experience cash flow problems. Consistent with comments from  the nonprofits we interviewed, this report suggested that payment delays  are especially difficult for smaller and new organizations because they do  not have established mechanisms to withstand delayed or unpredictable  funding.
section_title: Costs of Administering Grants
paragraphs: The high costs of grant administration sometimes discourage nonprofits  from applying for grant funds. Three nonprofits we interviewed reported  that they do not seek additional government grants or may not reapply for  grants they currently receive for this reason. For example, a Maryland  nonprofit official stated that her organization is eligible for a Recovery Act  grant program that provides services to youth, but she is hesitant to take  on the project because the grant’s administrative reimbursement rate is 3  percent, which would not cover the cost of administering the grant. Over  half of the nonprofits in our study said that administrative reporting  requirements make it challenging to administer grants they receive.
Officials from a Louisiana nonprofit told us that complying with reporting  requirements for the more than 20 federal grants they manage requires a  significant amount of staff resources. A Maryland nonprofit official  explained that some of the nonprofits’ federal grants are “big, complex,  and complicated” to acquire and manage because it does not have a  dedicated grants management team and establishing one would redirect  resources away from other areas. Likewise, officials from a Wisconsin  nonprofit said that complying with the county’s challenging bureaucratic  process requires a significant amount of time that could otherwise be  spent on mission-related activities, and that the organization regularly  loses money as a result of these requirements.
We and others have previously reported on the challenges facing  nonprofits in administering grants. In July 2007, we testified that  practitioners and researchers alike acknowledged the difficulty that  nonprofit organizations, particularly smaller entities, have in responding to  the administrative and reporting requirements of their diverse funders.  We said that although funders need accountability, the diverse  requirements of different funders make reporting a time-consuming and  resource-intensive task. For example, meeting the increasing expectations  that nonprofits measure performance, given the size of grants and the  evaluation capabilities of the staff, can be difficult. One researcher said  that performance evaluation is one of the biggest challenges they face. A  2002 study, which included an analysis of Internal Revenue Service (IRS)  Forms 990 from 1,172 nonprofit organizations from 1985 to 1995, found  that for some nonprofits, an increase in government funding is positively  correlated with an increase in the share of administrative expenses the  following year, which could be the result of the costs associated with  obtaining contracts and the challenges of meeting accountability and  reporting requirements. Similarly, a 2004 study on nonprofit overhead  costs of 9 nonprofit organizations reported that the nonprofits with the  weakest organizational infrastructures received half or more of their  revenue from public sector sources, and that the public sector practice of  providing little support for overhead costs was directly associated with the  organizational weaknesses at these nonprofits.
section_title: Conclusions
paragraphs: Federal, state, and local governments rely on nonprofit organizations as  key partners in implementing programs and providing services to the  public, such as health care, human services, and housing-related services.  Nonprofits’ ability to determine and manage their indirect costs is affected  by inconsistencies in terminology and guidance across federal programs  on how to classify costs. Further, varying reimbursement practices by  state and local governments that award federal funds affect the rate at  which indirect costs are covered. Absent a clear understanding among  federal, state, local, and nonprofit officials about how to interpret OMB’s  indirect cost guidance and consistently classify activities typically thought  of as indirect costs, nonprofits will likely continue to struggle with  accurately and consistently reporting on their indirect and administrative  costs of doing business, and a clear picture of the true gap between actual  and reimbursed indirect costs will remain elusive.
As the federal government increasingly relies on the nonprofit sector to  provide services, it is important to better understand the implications of  reported funding gaps, such as compromised quality of important  administrative functions, including information technology, human  resources, legal, and accounting operations. Such gaps further limit  nonprofits’ capacity to correctly determine how indirect costs should be  treated. Collectively, these challenges potentially limit the sector’s ability  to effectively partner with the federal government, can lead to nonprofits  providing fewer or lower-quality federal services, and, over the long term,  could risk the viability of the sector. Given OMB’s role in federal grants  management, OMB is in a unique position to convene stakeholders to  review these issues.
section_title: Recommendation for Executive Action
paragraphs: GAO recommends that the Director of OMB bring together federal, state,  and local governments, and nonprofit representatives to propose ways to  clarify and improve understanding of how indirect costs should be treated,  particularly for grants passed through state and local governments to  nonprofits by    clarifying the definitions of indirect costs and administrative costs and  their relationship to each other and    considering ways to help nonprofits improve their understanding and  ability to better capture, categorize, report, and recover indirect and  administrative costs.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to OMB and the Departments of Health  and Human Services (HHS) and Housing and Urban Development (HUD).  OMB generally agreed with our findings, conclusions, and  recommendations. OMB also provided technical comments, which we  incorporated, and suggested clarifying language for the recommendation,  which we agreed with and incorporated. HHS and HUD did not provide  formal comments, but made technical comments by e-mail, which we  incorporated.
We will send copies of this report to the Director of OMB and the  Secretaries of Health and Human Services and Housing and Urban  Development. In addition, the report will be available at no charge on the  GAO Web site at http://www.gao.gov.
If you have any questions about this report, please contact me at (202) 512- 6806 or czerwinskis@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to this report are listed in appendix II.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Our objectives were to provide information for selected federal grant  programs and nonprofits on (1) how indirect cost terminology and  classification vary, (2) how indirect costs are reimbursed, and (3) if gaps  occur between indirect costs incurred and reimbursed, steps nonprofits  take to bridge the gaps.
To address our objectives and obtain information on federal grants  initially awarded to state and local governments and passed through to  nonprofit service providers and the impact of indirect cost funding on  nonprofits, we used several approaches. These included selecting a  nonprobability sample of federal grants, states, and nonprofits to serve as  case studies and conducting a literature review to analyze published work  related to this topic. The scope of the third objective was broader to  include the perspectives of nonprofits that receive any federal funding,  direct or pass-through. We also interviewed nonprofit association officials.
First, we selected six federal grant programs—four from the Department  of Health and Human Services (HHS) and two from the Department of  Housing and Urban Development (HUD)—of 26 grant-making federal  agencies that offer over 1,000 grant programs annually. We selected HHS  and HUD as our two primary agencies of focus because of their familiarity  and historical relationship with nonprofit organizations. HHS and HUD  grants address many of the National Taxonomy of Exempt Entities  (NTEE) classifications related to social and housing services. The NTEE  classification system for nonprofits was devised by the Urban Institute’s  National Center for Charitable Statistics (NCCS), which is a national  clearinghouse of data on the nonprofit sector in the United States. NTEE  classifications are widely referenced by the Internal Revenue Service and  nonprofit researchers and practitioners. HUD and HHS grants address  NTEE categories such as:    Human Services    Housing and Shelter    Agriculture, Food, Nutrition    Community Improvement, Capacity Building    Youth Development    Health Care    Mental Health/Crisis Intervention    Civil Rights, Social Action, Advocacy  As shown in table 2, the six grants selected are designed to fulfill missions  consistent with most of the NTEE categories listed above.
Second, we selected three states for our case study—Louisiana, Maryland,  and Wisconsin—as well as local governments within those three states, as  appropriate. As part of our criteria for selecting states, we considered the  following:    Levels of HHS and HUD funding: We included states that receive  varying levels of HHS and HUD funding to observe how indirect cost  funding needs may be related to the amount of grant funding received by a  state.
Population: We included states with different population sizes to allow us  to examine potential implications for states that need to provide services  to larger numbers of persons.
Geographic dispersion: We included states that were geographically  dispersed to allow for regional representation across the country and  diversity with respect to the population receiving services; the economic  climate of the area; and other regional, cultural, and demographic  characteristics.
Third, we selected 17 501(c)(3) nonprofit organizations from Louisiana,  Maryland, and Wisconsin that receive at least one of the six grants we  selected. 501(c)(3) organizations are public charities that are eligible to  receive federal funding to support their missions of providing for the  public benefit. The nonprofits we selected had varying missions and  represented a wide range of operating budgets, from less than $1 million to  more than $25 million.
Once we selected our case study grants, states, and nonprofits, we  reviewed Office of Management and Budget (OMB), HHS, and HUD  documents, guidance, and policies governing the treatment of indirect  costs, and interviewed budget and program officials at the three agencies.  Further, we reviewed documents, guidance, and policies governing the  treatment of indirect costs from the selected states, local governments,  and nonprofits. We also interviewed budget and program officials from  state and local government entities as well as from nonprofit  organizations.
To further corroborate the information obtained from our case studies, we  reviewed existing research related to nonprofits’ indirect costs and overall  financial health. We used several search strategies to identify existing  studies. Through snowball sampling techniques, we identified research  and received study referrals from numerous nonprofit researchers and  other nonprofit groups. We conducted searches of several automated  databases, including Checkpoint, the Government Printing Office’s  Catalog, ProQuest, Lexis Nexis, Academic OneFile, and FirstSearch. We  also searched the OMB website, Congressional Research Service website,  and the Federal Audit Clearinghouse. We searched on various  combinations of the following terms: nonprofit, indirect cost,  administrative cost, cost, overhead funding, nonprofit funding, overhead,  administrative, pass through, grant, grantee, federal, fund, gap, and trade- offs. Finally, search results were limited to studies published after 1995.  Through our referrals and literature searches, we identified eight studies  and reports that were relevant to our work. We reviewed the studies we  included in our work to ensure that they were methodologically sound.
section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: Acknowledgments
paragraphs: Jacqueline M. Nowicki (Assistant Director) and Sonya Phillips (Senior  Analyst-in-Charge) managed this assignment. Carol Patey, Christine  Hanson, Mary Koenen, and Barbara Lancaster made key contributions to  various aspects of the work. Cindy Gilbert provided methodological  assistance; Donna Miller developed the report’s graphics; Sabrina Streagle  provided legal support; and Jessica Thomsen provided key assistance with  message development and writing.