Undercover Economist

Charity begins… in the back office

One handy way to size up a charity is to pay attention to how much it spends on overheads, rather than frontline do-gooding

You’re a generous person, I can tell. But how much do you think about the effectiveness of your charitable donations? One handy way to size up a charity is to pay attention to how much money it spends on overheads such as administration and fundraising, rather than frontline do-gooding. There’s only one small problem: this ready reckoner is enormously misleading.

For people who think about the effectiveness of charities, this insight is not news. Givewell, a charity that evaluates the effectiveness of other charities, complained five years ago about the “pervasive attitude that nonprofits need to get all their money right to the needy, and do all their administration on the cheap”. Dean Karlan, an economics professor and co-author of More Than Good Intentions, analysed Givewell’s recommendations and found that outstanding charities tended to spend more money, not less, on administration and fundraising.

Caroline Fiennes, author of a new book, It Ain’t What You Give, It’s The Way That You Give It, explains that fundraising costs tend to be determined by donors – who can generous or stingy, ignorant of the cause or conscious of it. Meanwhile, administration costs could include efficient logistics, accounting or purchasing systems – plus paying for rigorous evaluation.

It isn’t just in the world of charitable giving that we pay too much attention to administrative costs. Government ministers of all stripes love to claim that they will cut bureaucracy, sacking administrators and managers and investing the savings in “teachers and nurses”. If your child’s school is closed for a day or so because the heating fails, or your operation is cancelled due to lack of surgical supplies, then you can at least console yourself that those pesky administrative costs are being thoroughly squeezed.

The truth is that in the modern world, a surprising amount of money is spent on what one might call transaction costs. One definition of a transaction cost is any cost that Robinson Crusoe could never conceivably have faced. Costs of processing trades, searching for bargains, standing in line and suing for breach of contract are all transaction costs. So, arguably, are the costs of maintaining accounts and filing (or avoiding) taxes.

John J. Wallis and Douglass North, in a book chapter published in 1986, tried to estimate the importance of transaction costs in the US economy between 1870 and 1970. For simplicity, Wallis and North tried to define whole job categories devoted to supporting transactions (these include managers, sales assistants, lawyers, police and accountants) and also sections of the economy, such as retail, which were almost entirely devoted to supporting transactions.

Wallis and North reckoned that the production of the economy devoted to transaction services had more than doubled over the century, from 26 per cent of gross national product in 1870 to 55 per cent of GNP in 1970. Public sector transaction spending had grown especially rapidly, but from a low base, and the lion’s share of transaction costs remained in the private sector: a total of over 40 per cent of GNP – an awful lot of administrators. All waste? Surely, the story is a continuation of what Adam Smith identified back in 1776: increasing productive power thanks to specialisation and the division of labour. A subsistence farmer may have overheads, but he needs few transaction services. A modern city-dweller, who continually does business with strangers, lives and breathes them.

Spare a thought, then, for the humble back office. Not only are administrators, accountants, lawyers and managers necessary to make a charity work efficiently – such people make the modern world possible.

Also published at ft.com.