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Overhead Defined

Dear Dave
Could you provide me a definition of overhead, along with guidance for how I should compute overhead at our firm? What is the average overhead rate for firms? I own a land surveying firm with about 25 employees.
JR State Unknown

Dear JR
Overhead is made up of those items of a firm’s cost which are not assigned directly to a specific client project because they are either common to all projects (rent) or they would be far too difficult, silly or expensive to track and allocate back to each project (paper clips).

In order to determine overhead, a firm’s accounting system must be capable of separating project-related costs (direct cost) from non-project-related costs (indirect cost). This process is referred to as cost accounting.

Direct cost consists of the salary and wages paid to staff for work performed on client projects (direct labor) along with any sub-consultants, materials and other expenses specifically incurred for a client project. If an item of expense is a direct cost, it is never part of a firm’s overhead.

Indirect cost consists of that portion of a firm’s payroll not associated with client projects such as vacation, sick, general office time, etc. (indirect labor), along with benefits, taxes, heat, light, rent and other non-project-specific expenses. These indirect costs form what is sometimes referred to as the overhead pool.

Occasionally, for reasons of either firm preference or client requirements, the overhead pool is split into two separate pools. One pool consists of the cost of paid benefit time off along with payroll taxes and other staff employment benefit-related expenses (Direct Personnel Expense). The remaining pool is made up of heat, light, rent, etc. (General and Administrative Expenses). Unless otherwise required, my advice would be to stick with a single pool for simplicity’s sake. Why make something more complicated than it needs to be?

Overhead is the ratio of the overhead pool to direct labor where the overhead pool is the numerator and direct labor is the denominator. The resulting overhead “rate” is commonly expressed as either a percentage of direct labor, or as a multiple of direct labor. By the way, managing staff payroll to maximize direct labor (increasing the denominator while reducing the numerator) is probably the single most effective and dramatic way for a firm to control its cost of operations as expressed by the overhead rate.

Based on several recent national surveys, the median break-even overhead rate (before bonus, other discretionary payouts, and any business level income taxes are added to the overhead pool) for all sizes and types of firms is about 145%, or expressed as a multiple of direct labor, 2.45. In other words, for every dollar of direct labor spent on client project activities, the average firm must recover that dollar plus an additional $1.45 of overhead to meet their break-even expenses. Caution: Profits are above and beyond the overhead rate and need to be added in when setting the full multiplier on direct labor you will use to either budget or invoice projects.

Overhead rates can be difficult to get a handle on as no two firms’ overheads are ever going to be the same due to individual judgments firms make when setting up their cost accounting systems. For instance: As a matter of policy Firm A may decide to charge administrative time directly to projects and invoice it to clients as a direct project expense. Firm B may decide it is not worth the bother and by policy classify all administrative time as indirect and include it in the firm’s overhead rate. All other things being equal, Firm A’s overhead will be less than Firm B’s. If you weren’t intimately familiar with each firm, how could you draw an arm’s-length conclusion by comparing each firm’s overhead rate?

I advise my clients to calculate their firm’s overhead at the end of each monthly accounting cycle and to dig into details deeply enough to fully understand why the overhead rate has changed the way it has from one month to the next. I further recommend that they track a twelve-month rolling average overhead rate by adding the current month to the latest eleven months to look for long-term trends. Since overhead rates can be quite volatile from one month to the next, a twelve-month average is a much more suitable indicator to draw conclusions from and base decisions on.

Wahby and Associates