Ask the Experts | How to Allocate Overhead

Question: “When should I expect to receive my financials from our accountant each month? And how do I read my profit & loss statement?”

Gary Elekes; Founder, EPC Training: This is a complicated question, so we’re kind of diving in right off the bat. Overhead allocation is a step beyond the gross profit line being departmentalized.

So, when allocating overhead to the service department, replacement department, new construction, commercial – any of the departments – there’s basically some principles that we follow. Then there’s one basic principle that we’d outline that would be sort of “Don’t do this one.” So let’s start with the “Don’t,” because it’s the easiest one.

A lot of accountants or financial folks will use the percentage-of-sales method to apply overhead into the departments based on what they sell, and that’s the only method that you really don’t want to use. It’s eminently flawed because, if you think about it, if you raise your price 5% in the marketplace, you really haven’t created any additional overhead. You’ve gained 5% of gross profit dollars and overall profitability. So no additional overhead is created. Percentage of sales method is used because it’s the easiest method, so people get trapped into that idea.

So with that in mind, the main concept about overhead is it’s really driven in the service industries by the labor. And so the labor is part of the cost of goods sold. So we’ll use three methods to determine how we’re going to allocate overhead.

The first method is simply direct expense. You really just look at any chart of accounts list, go through the whole list, and ask the simple question, “Does it apply as a direct expense?”

So if I have a service truck and I have a service technician and he really is, or she really is, dedicated to the service department, and that’s the only work they do, that’s pretty easy. And then you could say the same thing about the gas card there, and the uniforms and the various expenses that would attach to that individual’s vehicle.

In a smaller company, where you’re spreading out lots of different people over many different departments, that’s really where you get into the second layer.

So the second discussion is percentage of labor in each of the departments, divided by total labor of the whole company. So the service department – if that’s the question we’re talking about – we would look at the service department direct labor not including benefits, just the W2 wage. And then we would divide that by the total direct labor of all the departments combined, and we would come up with a ratio. And if we looked at all of the percentages, hopefully they’d add up to 100%, the service department would have its percentage.

What really we’re looking at from an accounting and financial point of view is that whatever dollar of labor we spend, some portion of overhead is being created based on the usage of labor. And that varies quite a bit from material, because high-material low-labor type of work is similar to sales: it’s very profitable, we love it, but it really doesn’t produce much overhead at all. So labor is the one variable that sort of creates the dollar in the overhead category. Especially what we would consider to be the variable costs; fixed costs are generally not moving around much.

So those are the first two methods, and then the third method, after we’ve gone through all of the chart of accounts with the first method, and then we go back and we go through all of the chart of accounts with percentage of labor, what’s left over?

And there might be some remaining accounts left over, such as general manager’s salary, or bonus programs, you might have a discussion about rent and some of those types of things.

So the third is, we really look at managerial discretion. We do an assessment of the core departments inside of a business. Service would certainly be one of those, and HVAC and plumbing, and we would use management discretion. So typically what we’d do in the financial class or the budgeting class is just make a comment box in Excel and make sure we annotate how we’re thinking logically about this application of overhead. And so we can then apply those – so our company, we have six core departments we spread rent relatively evenly across the board.

There’s a fourth method, which some people might want to use, that’s percentage-of-square-foot method, but personally I think that that gets overcomplicated; it’s already complicated enough, so we’re already taking a subject matter that is a very sophisticated, advanced financial concept and then we’re breaking it down. But I’ve found that percentage-of-square-foot method doesn’t really add any differences, it really only applies to one area – rent.

So those would be the three methods we would use, and then we would finish out the chart of accounts. So the service department prototypically ends up with an overhead that’s somewhere between forty and fifty percent of the overall costs associated with the business. And most of that is applying based on the idea that variable costs – things like gasoline and workman’s comp and those sorts of things – are moving around with the percentage of labor method.

If there’s any questions, there is a pretty detailed article inside the Financial Structure section of the Contracting Best Practices Library on egia.org, I believe it’s about a 13-page outline on how you can allocate overhead. I go through some chart of accounts and some other examples.

The last comment I’d make is the larger you are, the more specialized you tend to become. So it’s relatively easy for a larger company to do it, because a lot of the direct expense method applies.

In a smaller entity that’s doing allocations, typically you have to do some percentage of labor method because there’s not a lot of direct expense. We’re moving people around on, you know, the service board to do maintenance and we might have them do installation, we might have them to some commercial service, commercial installation, so the percentage of labor is really how we can dictate that.

Drew I don’t know if you have anything to add…

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