Proper Placement of Overhead

March 25, 2016

Most conversations about overhead turn out to be complicated and emotional. People are confused about how it is defined, how it is calculated, and above all, how it is recovered. Everyone does it differently, and no one is happy. defines overhead or indirect costs as “those administrative expenses of a business that are required to operate general corporate functions, and which cannot be definitively attributed to any revenue-generating activities or units of output.”

The definition raises two critical questions. First, how do you define the “general corporate function” covered by the expenses? Second, how do you definitively attribute these costs to a revenue-generating activity or unit of output and thereby establish the mechanism used to recover the expenditures involved?

Let’s define three distinct types of indirect costs and see if we can answer the questions. Everything is summarized in the table.

Indirect Costs

Type of indirect cost General corporate function Types of costs Costs attributed Cost recovery
Labor burden To provide for labor costs over and above an employee’s base pay Taxes, insurances, fringe benefits and allowances

As an add on or burden on payroll costs

By charging a burdened labor rate for each hour worked by the employee
Shop, yard indirect costs To provide for the shared, facilities space and resources needed by the fleet Rent, utilities, labor, equipment and materials required to run shop and yard operations As a defendable add on to the rate charged for units supported by the shop and yard resources Through the productive use of the equipment supported by shop and yard resources
Overhead costs To provide administrative and accounting services at a company level Management, administrative, accounting and IT costs Remains as part of the company overhead Not recovered through production.  A deduct from Gross Profit

Labor burden

“Labor burden” covers all the costs over and above an employee’s base salary that are directly associated with the employment of the individual. They fall into three broad categories: taxes such as social security and unemployment compensation; insurances such as worker’s compensation and public liability; and fringe benefits such as insurance or pension benefits, vacation time, training time paid by the employer, as well as various allowances such as personal tools and travel.

These costs are directly associated with the employment of the individual and can be “definitively attributed” to labor hours or payroll cost. This is done by calculating a “burdened labor rate” that includes all the costs that fall into this category and recovers them by charging the burdened labor rate for the time worked by the individual.

The calculation of a burdened labor rate is not straightforward. Do you calculate a burdened rate for each individual based on each employee’s base pay, or do you calculate an average burdened rate for a particular trade or job category based on the average base pay for all employees in that trade or job category? Also, the burdened rate depends on the number of hours an employee works and charges their time to a “revenue-generating activity.” Vacation is obviously a deduction from available billable hours.

What about time needed to perform routine administrative tasks? Is this time deducted from available billable hours or is it charged to a specified indirect cost code? Issues like this have a significant impact on the burdened labor rate and are frequently not explicitly spelled out.

Shop and yard indirect costs

Shop and yard indirect costs are different from labor burden. They arise because the company must provide the shared facilities, space and other resources required to maintain a home base and repair facility for the fleet. Yard operations, dispatch, field support, basic emergency repair, and short-run fabrication capability are core competencies within an equipment-intensive operation. Providing the facilities and management required to do this is a “general corporate function.”

It is no trivial task to define and manage the shop and yard indirect costs. Rent, property taxes and utilities associated with the shop and yard are easy to define as is the cost of the management supervisory personnel directly associated with shop and yard operations. But when do shop supplies stop being shop supplies and start being parts billed to a particular work order or equipment unit number? When is time spent planning work and keeping the shop neat and tidy billed to the shop indirect cost code and when is it billed to a work order or equipment unit number?

Shop and yard indirect costs mount up quickly, and disciplined action must be taken to ensure that shop and yard indirect cost codes do not become a dumping ground for costs that are more appropriately charged elsewhere. This is particularly true of yard operations where work done to stage, load and dispatch equipment or supplies to sites should be coded to job mobilization and not to a general shop or yard indirect cost item. The same is true when allocating labor costs. Everything possible must be done to ensure that time is correctly coded to work orders or equipment unit numbers and not, as is so often done, to incorrect indirect cost codes.

The most controversial conversations surrounding shop and yard indirect costs relate to the way in which these costs are attributed to or recovered from “revenue-generating activities or units of output.” The “allocation base” or the “basis upon which an entity allocates its overhead costs” is invariably the subject of heated discussion.

There are two schools of thought. The first suggests that indirect costs can be definitively attributed to labor hours worked in the shop or yard. All shop and yard indirect costs should therefore be recovered by means of a fully burdened labor rate that includes both the general payroll labor burden and an additional mark-up required to cover shop and yard indirect costs. Proponents give two reasons: Dealers do it this way, and it is the only way they can compare their costs with the dealers’ costs. This works for dealer shops because they sell labor hours. It is their principal output, and the rate they charge is their principal source of income. The more labor hours they sell, the more likely they are to fully recover their indirect costs.

The second school of thought understands that dealer shops and contractor shops and yards are different. They argue that contractor shops do not sell labor hours, and labor is an input rather than an output. They suggest that the output from a contractor’s shop is functioning equipment working reliably in the right place at the right time. They know that it is extremely dangerous to attribute overhead to an input and to base overhead recovery to the volume of input used.

This school of thought understands that a dealer’s shop is different from a contractor’s shop and yard. They know that regardless of the way you assign indirect costs, you cannot compare apples with oranges.

Contractors must not attribute shop and yard indirect costs to labor. When this is done, overhead cost recovery problems are frequently “solved” by increasing inputs, adding unnecessary labor, and reducing the focus on efficiency.

Contractors must attribute shop and yard indirect costs to their principal output: functioning equipment working reliably in the right place at the right time. This is not easy, and as with any cost allocation process, there is no perfect solution. The allocation base used for budgeted costs and the actual costs will always be controversial. So keep it simple. Use known values such as the unit’s rate, the unit’s operating cost rate, the unit’s original capitalized value, or the simplest of all, a straight burden on every unit in the fleet. Understand and defend the methodology and focus on recovering overheads through the productive use of the equipment supported by the shop and yard.

Corporate overhead costs

Most companies perform some of the general corporate functions associated with the administration and management of their equipment fleet at the corporate level. The costs involved will include those associated with accounting, finance, human resources, IT and executive leadership. These overhead costs are frequently not definitively attributed to the cost of a revenue-generating activity or unit of output. They are therefore left as part of the company overhead and absorbed as a deduct from gross operating profit.

Indirect cost definition, budgeting, allocation and recovery is a complex process. Always remember that the most important thing to do with an indirect cost is to eliminate it. Work to answer this question: How can I direct charge this cost and stop it from being an unmanaged indirect cost that will, one way or the other, be the subject of a less than perfect attribution and recovery process?

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