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What is Cost-Effectiveness?

Why does it matter?

Cost-effectiveness is often viewed as anathema to the nonprofit sector. We see it as the opposite. Take a simple thought exercise: A program has a limited budget of $100,000 to improve literacy in a community. It can choose between two approaches to do so: one that can boost literacy by a grade level for 100 students ($1,000 per student) and a second that can also boost literacy by a grade level but for 200 students ($500 per student). All else equal, a sensible program administrator would choose the second, as of course it reaches twice as many students. 

This is a cost-effectiveness decision.

Backing up a little, let’s get a few terms clear. We talk a lot about two related, but distinct concepts: impact and cost-effectiveness. Colloquially, the two are often used interchangeably, and we’d be lying if we said that every once in a while we didn’t slip up and use the wrong one. However, we can’t fully understand the process of evaluating nonprofits without a grasp of what makes these two ideas different.

First, let’s take impact. Impact is what a nonprofit can do for a cost. “$500 boosts a student’s literacy by one grade level” is a statement about impact. It’s the bedrock of what we do, but we need more than just impact to tell if a nonprofit is using its resources wisely. Could those resources be put to better use elsewhere? Maybe by using resources more efficiently or by tackling the same problem a different way? To put it simply, if I say a nonprofit boosts literacy by a grade level for $500, the natural next question is “So, is that good?”

This is where cost-effectiveness and benchmarks come in. Cost-effectiveness is impact in reference to some benchmark. If estimates of impact are just an ocean of dollar values to achieve some outcome, benchmarks are the buoys that gives us a sense of where we are. Think back to our example above, we only know that the program that boosts a student’s literacy grade level for $500 is cost-effective because we have the context of another program that does the same thing for twice as much money.

Cost-effectiveness is all about situating an impact estimate in some sort of context — giving it some point of comparison. For the nonprofits we rate, rather than using peer performance, we determine cost-effectiveness based on predetermined benchmarks. Take, for example, a water purification program with the impact statement “$4 provides clean water to a person for a year.” So, is that good? To answer that, we compare the impact estimate to the market price a beneficiary would have to pay for a year of water had it not been provided by the nonprofit. Now we can see that $4 for a year of clean water is substantially less than what someone would otherwise have to pay, making it a cost-effective use of resources. Again, here you can see that on its own, the impact statement didn’t tell us anything about how cost-effective the nonprofit was; we were only able to make that judgment once we had a point of comparison. [You can read a more technical explanation here about our different benchmarks and why we use them.]

These examples show that impact and cost-effectiveness are fundamental tools donors can use to do more good with their money.

A quick caveat: impact and cost-effectiveness aren’t always possible to ascertain for nonprofits. Nonprofits that engage primarily in advocacy, for example, pose a challenge to researchers and raters. While these organizations may be highly effective, the link between their work and outcomes is longer, and often there are alternate explanations for why a certain piece of legislation was passed or people’s attitudes shifted. We don’t (yet) have a good method for estimating the impact of these programs, and so we don’t evaluate their impact or cost-effectiveness. We also know that some large donors care about things other than cost-effectiveness, such as the capacity to absorb more funding.

Nonetheless, cost-effectiveness is a critical tool in donors’ decision-making toolbox. We have limited resources and unlimited needs. Cost-effectiveness analysis enables those resources to go further, helping more people in more ways.