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Labor Overhead Rates

Accounting For Labor Overhead ExpenseI am working on a project to create a simple P&L by product line. 75% of our cost are development so we have created a program the tracks their time by product line. What we are trying to determine is what is the best overhead rate to use to create the labor rate. What we have used in the past is Wages times Overhead Rate which is based on Benefits, Payroll taxes for Development. My financial analyst thinks that we should include all costs for Development, Marketing, G&A etc to determine the rate so that the numbers essentially tie to the overall expense numbers in the P&L. I just wanted to know what others may or may not be doing in this area. Again, we don't have an elaborate system, however, we are trying to get a better handle of our product by product line.


Doug Devlin
Title: Doug Devlin (CEO at Zuman) expert
Company: Zuman
(Doug Devlin (CEO at Zuman) expert, Zuman) |

In my experience the question of which overhead rate depends on four factors.

1) Who are the readers of the Product Line financial statements
2) Company size
3) Would the overhead expenses be present without the product line
4) Agreement with Product Line Managers on the overhead rate

Agreeing with interested parties on the formulas for allocations is probably the most critical step, especially when product line financial performance is linked to compensation. Getting the most accurate number can prove illusive as allocations can become technical and difficult to explain to the reader. For instance, some organizations go as far as allocating the cost of capital to projects which would be difficult and timing consuming task for a small company.

The best overhead rate is the one you have an agreement with the Product Line Manager and that the Product Line Manager can clearly explain in front of their superiors. If you don't have agreement, the Product Line Manager will have you explain why you have allocated these expenses to the product line. It becomes a no win situation for a VP of Finance as the Product Line Manager needs to own the product P&L. Even if your executive team is acting as the Product Line Managers the same rationale applies about getting agreement. First time Product Line Managers will need a great deal of coaching.

You may want to see my post answering a similar question on direct allocation of expenses in the forum

Topic Expert
Patrick Dunne
Title: Chief Financial Officer
Company: Milk Source
(Chief Financial Officer, Milk Source) |

Probably the simplest answer is applying all costs you mentioned if they relate to the business or product produced. I would not allocate activities that have nothing to do with the product development/production or sale. You may want to pull out activity based costing (ABC) materials to more fully understand what costs to allocate.

Topic Expert
Joseph Ori
Title: CEO
Company: Paramount Capital Corporation
(CEO, Paramount Capital Corporation) |

Have you considered activity based costing, ABC, instead of job based costing? It will provide a truer costing amount, more reliable GP and higher productivity. In ABC, determine cost pools like HR dept, mktg, g&a, finance, etc and then drivers in the cost pools like hrs, mktg plans, g&a hrs, etc. Once you have the pools of OH costs and drivers, the cost per each driver can be used to apply OH.

Topic Expert
Edward Abbati
Title: Vice President of Finance
Company: Location Labs
LinkedIn Profile
(Vice President of Finance, Location Labs) |

I have consider ABC but the issue right now is that I don't have the staff nor the systems to implement it. I am trying to start with something simple that is seen of value. Once I get something going, I will looking to improve the overall program.

Len Green
Title: Performance Improvement Consultant and E..
Company: Haygarth Consulting LLC
LinkedIn Profile
(Performance Improvement Consultant and ERP Strategist, Haygarth Consulting LLC) |

Here's my perspective:

When you look at including overhead costs into product P/L analyses, there are a few levels at which this can be done. However, a number of principles should be examined: 1. are overheads direct (product related) or indirect? 2. Are overheads fixed or variable (within the analysis time frame)? 3. apply the Contribution approach.

Sometimes people fall into the trap of trying to arithmetically spread overheads across products simply to "balance to the GL." That's "nice" but not always a good idea.

Direct costs (and revenues) can normally be controlled (to some extent) by the line managers. In your case, you want to "determine...what is the best overhead rate to use to create the labor rate." Make sure you isolate direct labor first, then identify the benefits burden rate for that direct labor.

Regarding Development + Marketing, first of all calculate your product contribution (contribution 1-direct revenues net less direct costs), then try to isolate which costs are directly related to which products. Deduct those direct overheads from contribution 1 to get to contribution 2. Then you can evaluate indirect overheads and deduct them from contribution 2 to get contribution 3 - at this level 3 you are likely aggregating products/product groups to get to a business unit/company level.
This happens often where some overheads have to be compared to product group, not specific products (e.g. G&A, General Marketing...).

Often the relationship between sales volume and some overhead costs is not linear; in marketing there may be a timing difference anyway (promote the product this quarter, increase sales next quarter). So decide if you need to make a "timing" adjustment - but that kinda blows the efforts to tie to the GL:). How granular is your chart of accounts (e.g. cost centre/product line dimensions)?


Mark Matheny
Title: VP - FInancial Planning and Analysis
Company: Novolex (formerly Hilex Poly)
(VP - FInancial Planning and Analysis, Novolex (formerly Hilex Poly)) |

It depends on how the analysis is going to be used. If the intent is to show the incremental profitability than only truly variable costs or fixed costs that would go away if the volume was eliminated should be included. If it is for a broader view of the total business by product line, then some amount of activity based cost analysis should be done to allocate overhead.

Bob Low
Title: Principal
Company: Perron & Low
(Principal, Perron & Low) |

I would not attempt to tie it out to the P&L. Main reasons are 1) focus should be on costs related to the projects. Spreading costs unrelated to the projects doesn't further the decision making process. 2) You will need a basis for making the allocation (labor hours, total wages, total spend, etc) and run the risk the choice of factors distorts the analysis. 3) You might want to track things differently than GAAP accounting. Perhaps you want to recognize the value of a new contract but GAAP requires revenue to be deferred. Or you want to track cash flow but GAAP requires fixed asset purchases to be capitalized and depreciated. Maybe you want to spread the value of an advertising campaign or track metrics like customer retention.
I'd suggest something along the lines of what I think Len is saying: start with revenue; then deduct direct expenses (wages, fringes, commissions, etc) to get a direct margin. Capture as much as you can that is direct -- i.e. can spending on travel and IT be tracked directly to certain projects? Then allocate things reasonably related to drivers you can track (i.e. telecomm might be allocable based on heads, many sales expenses related to revenue) to get indirect expenses and a gross margin and stop there. If you want to equate this gross margin to net income, you can calculate what percentage of revenue unallocated expenses add to and let managers know that but I'd prefer just setting a target for gross margin.

Topic Expert
Malak Kazan
Title: VP, Special Projects
Company: ERI Economic Research Institute
(VP, Special Projects, ERI Economic Research Institute) |

I would add if there are additional compensation components other than a standard base salary , include some reasonable estimate for these in the labor OH rate as well (i.e. cash incentive plans etc).

Theresa Wilt
Title: Consultant - DCAA/ FAR/ CAS Guidance + A..
Company: T W Consulting, Inc.
LinkedIn Profile
(Consultant - DCAA/ FAR/ CAS Guidance + Accounting system setup , T W Consulting, Inc.) |

In my opinion, you cannot properly measure and manage total cost unless you fully allocate all of your indirect costs to your direct costs on a causal beneficial basis.
You cannot truly determine profitability of a project or a product without including
the total cost as allocated. You want to always maximize your total billable cost to
customers to cover them and make a profit on top of that and just can't do that as
precisely any other way. The best indirect rate structure for a business depends
on the company and many factors about them which I could discuss for days with
anyone who wants to know more on this topic, but out of about 100 clients, I find
this structure to work best for the majority:

Indirect cost pool /direct cost base = rate (rate is applied as a burden % on base)

1) Fringe benefits / total labor dollars
2) Facility cost /square feet of usage
3) Overhead cost / direct labor dollars
4) M&S Admin / materials & subks *
5) G&A expense / total non-G&A cost

* M&S is optional and only makes sense if you have significant Mat/Subk costs
** Large companies may have multiple OH rates, such as Mfg. vs. Engineering, etc.
I should mention, I work in the GovCon industry and this accounting is required
That's my two cents and any of my many clients (on LinkedIn) can attest to that.

Hope this helps,

Andrew Nussbaum
Title: Director of Finance and Adminstration
Company: **--**--**
(Director of Finance and Adminstration, **--**--**) |


Going to agree with Ms Wilt on this one --- you need to allocate indirect costs represented by your product team (facilities (sq ft), utilities, and all others as detailed in her response) -- If the team were not conducting that product dev, those costs wouldn't exist.

I have many years experience in Govt O/H as well and we accounted for everything... as rule of thumb, I like to use a factor of 2.2 or 2.3... I have found this quite accurate for quick calculating or if you don't have resources for in-depth analysis.

So equation looks like: D/L($) * 2.2 or 2.3 ---- $50/ hr (D/L)* 2.3 = $115/ hr fully burdened -- using this equation has been much cleaner than WAGs and quick.

Hope this helps!



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