Salvation Army defends £16.3m it received over same period for its charity work but others feel the balance is wrong

An austere portrait of the founder of the Salvation Army, William Booth, stared down on Nigel Hanger as he justified his multimillion pound earnings from its clothes recycling scheme.

On the boardroom table of the church's office in Wellingborough, Northamptonshire, lay accounts detailing how the 56-year-old textile trader has amassed up to £10m in the last five years selling jackets, shoes and jeans dropped by supporters into clothes banks.

"Profits are good," he told the Guardian. "We have been very successful increasing the tonnage and in the last two or three years. The market has never been as buoyant."

He was responding to an investigation that showed that in the last three years Hanger and his fellow directors in the private company running the scheme for the Salvation Army have earned more than £10m while the charity has received £16.3m which goes towards the £150m it spends annually on "the relief of poverty and the advancement of education".

Ian Ross, 75, who was pushing his old wax jacket into one of the Salvation Army's banks less than half a mile away at the town's Tesco car park, knew what he thought about Hanger's earnings.

"That is wrong," he said. "Anyone would believe the donations are going to the benefit of those that need them, not to somebody who is making a massive amount of money. I will think twice about doing it again."

The Salvation Army has defended its arrangement while Hanger argues he has done nothing wrong.

"You would pin a medal on the top business people [for achieving these profits] but because this is a charity you think there's something strange going on," Hanger said. "At no point have I ever not said what I am in this for. I am in business to make profit as best I can in the proper manner and to make as much money as I can for myself and my family."

Lieutenant Colonel David Hinton, the Salvation Army's secretary for business administration, said: "In the past three years alone, this has resulted in the donation of more than £16m, money which we would not otherwise have received from a national recycling and shop operation."

The differing perceptions illuminate a contradiction at the heart of modern charity finance, where good causes are increasingly impelled to embrace capitalism to maximise their earnings.

In the process they risk undermining the charitable values they were set up to promote.

The issue erupted in 2006 when donors were advised to reconsider giving to the Children in Need appeal because it spent £2.4m on administration costs to raise £33m. In 2007, Wooden Spoon, rugby union's charity fronted by Lawrence Dallaglio, a former England captain, and Princess Anne, was exposed for spending up to two-thirds of its income on activities including banquets and golf days.

Signing private sector deals to recycle cast-off clothes has become the latest attraction for charities as the price paid rose from less than £100 per tonne to more than £350 between 2006 and 2009. The Salvation Army's arrangement with Hanger, a second-generation textiles trader from Kettering, was one of the first.

Hanger set up Kettering Textiles Limited (KTL) in 1991 to serve the Salvation Army. By 2003 he had been appointed director of the charity's trading company, allowing him to sit on both sides of a deal from which he has benefited handsomely. Trevor Caffull, managing director of Salvation Army Trading Company (SATCoL) with whom KTL has a contract, and Hanger deny any conflict of interest.

Collections have risen to 2,500 tonnes a month, meeting soaring demand from secondhand shops springing up in eastern Europe. The latest accounts filed at Companies House show that in 2010 Hanger drew a £1.6m dividend and one director was paid £1.275m. In 2007 Hanger bought a house in the village of Finedon for almost £1m.

A tax accountant who donates to the Salvation Army scrutinised the accounts and concluded: "The balance between what the Salvation Army is making and what Hanger is making seems wrong." He said: "It has come as a complete surprise to me that this is the case and you have to ask how far the Salvation Army is getting the best deal with Hanger sitting on its trading company board." The relationship between KTL and SATCoL is undeniably close. Not only is Hanger on both boards, they share the same head office. Despite the close links, the Salvation Army said it had no say over how much the directors of a private company pay themselves. Hinton stressed the deal with KTL has proved beneficial to the Salvation Army over many years and had been "carefully worked out".

He said: "The recycling business is now a fiercely-contested industry but by continuing to work closely with those organisations with whom we have a strong relationship, we are confident that the Salvation Army benefits as much, if not more, than were we to work with another company." Maria Chenoweth-Casey, chief executive of Traid, a charity which earns most of its money by recycling clothes for the benefit of international aid projects, said it was increasingly common for private companies to take a bigger share than the charity: "Normal people aren't aware of this and where the money goes should be prominently displayed on textile banks and it should say who is profiteering."

"Supermarkets feel very safe hosting Salvation Army banks, but other charities are losing opportunities ... there is more to the Salvation Army's textile recycling than meets the eye."

The Fundraising Standards Board, the self-regulation body for charities, is consulting on a code of practice that will demand clearer labelling of house-to-house collections and textile banks. The Salvation Army said it is starting to change the wording on its banks to make clear that "of the net proceeds, two-thirds are retained ... and one-third is passed to Kettering Textiles Limited." The process will be complete within six months.

Hanger said he is planning to retire from the businesswithin the next 18 months and will not seek another contract with the Salvation Army.

Budapest bargains

The British flag is visible on almost every high street in Hungary, pinned up in shops to show secondhand clothes from the UK are for sale. With fewer and fewer Hungarians able to afford new clothes, they are buying secondhand from Britain for as little as 10% of the price they would pay new.

"Look at this cardigan," says Judit, a shopkeeper in Maggie's London, the third British shop in Budapest's Bartok Bela Street. It's pink, with a Marks and Spencer label, and costs 2,200 forints (£6.91). The shop is packed with women sifting through the latest stock, which arrives by the tonne each Wednesday evening. "Marks and Spencer and Next are the most popular," says Judit. She lists five reasons for the growing appeal of shops like hers: cheapness, quality of British brand names, bigger choice than in ordinary shops, larger sizes available, and the fact that people are more environmentally-minded than they used to be – they don't mind wearing other people's cast-offs. "I used to buy only new clothes," admits Melinda, a customer trawling through a long line of blouses and skirts. "But times have changed."

Further down the street, at a shop called English Clothes, they sell by weight, rather than by item.

Cheap English clothes shops are changing the face of Hungarian cities. In Budapest, the grand boulevard now boasts dozens of them, easily outnumbering cheap Chinese clothes stores. In 2009 the number of used clothes shops tripled, according to the economic daily Napi Gazdaság. The Salvation Army sells hundreds of tonnes a year of donated clothes to Hungary.

Nick Thorpe in Budapest