Academic journal article Atlantic Economic Journal

A New Cost Efficiency Measure for Not-for-Profit Firms: Evidence of a Link between Inefficiency and Large Endowments

Academic journal article Atlantic Economic Journal

A New Cost Efficiency Measure for Not-for-Profit Firms: Evidence of a Link between Inefficiency and Large Endowments

Article excerpt


Research on the performance of not-for-profit organizations has typically focused on their delivery of program services. The National Center for Chantable Statistics, a primary source of data on these organizations, collects information reported on the IRS Form 990 filed by these organizations. While these organizations do not generally pay taxes, most of them must nevertheless file the Form 990 annually with the IRS. It contains information derived from the income statement and balance sheet and divides all expenditures into three broad types: program, management, and fundraising. Research using the Form 990 data to evaluate the performance of not-for-profit firms often employs the ratio of program expenses to total expenses to gauge the effectiveness of organizations in delivering services. For example, Core et al. (2006) employ the program expense ratio to consider whether large endowments insulate not-for-profits from donor and market discipline and reduce their effectiveness at delivering program services. Desai and Yetman (2006) use the program expense ratio to examine how differences in the strictness of the regulation of not-for-profits by states influence their delivery of services.

A higher ratio of program expenses to total expenses suggests a not-for-profit organization delivers its program with fewer total expenses devoted to management and fundraising. In short, it is more cost efficient than those with a lower program expense ratio. While a higher program expense ratio indicates higher cost efficiency, it does not indicate the best-practice level of costs and the divergence of any particular organization's cost from best practice. Such divergence can gauge the extent of agency problems.

Many studies have directly estimated cost functions and cost efficiency for a variety of organizations, both for profit as well as not for profit. These studies typically focus on firms in industries with detailed data on production and cost, such as banking and health care. (1) The data on not-for-profits obtained from the IRS Form 990 lack these details and, consequently, encourage substitution of the program expense ratio for the direct estimation of cost efficiency.

While the IRS Form 990 data are not ideal for estimating cost efficiency, they nevertheless allow the estimation of a simple cost function and cost efficiency by adapting some of their variables to proxy for more standard outputs and inputs. The focus of most studies on program expense suggests that program expense can be used as a proxy for the primary output of a not-for-profit organization in the Form 990 data. The indirect cost of delivering any amount of program services is the sum of the management and fundraising expenses. The fundraising components of this sum of administrative costs point to another potential output, total contributions raised, which occasions some of these administrative costs. Thus, the Form 990 administrative cost function consists of the sum of management and fundraising expenses as a function of the two outputs, program expense and total contributions raised. In addition, since labor and physical capital costs differ geographically, it is important to control for these differences in the cost function. In a particular not-for-profit sector, the best-practice organizations minimize the administrative expense of any given level of program service expense and contributed funds and input prices.

When most studies use the ratio of program expense to total expenses to gauge and compare the effectiveness of charities in delivering services, they implicitly assume that the quality of each dollar of program expense across charities is homogeneous. In using program expense as a proxy for the output of program services in the administrative cost function, the same assumption of homogeneity must be made. In addition, if the administrative cost function takes on a sufficiently flexible functional form such that the marginal administrative cost of an additional dollar of contributions raised is not necessary constant, the efficiency of fundraising can be investigated. …

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