|  The Strategic Use of Overhead Allocation Too many companies misunderstand overhead allocation and fail to use it to its full potential. They simply apply overhead in a standard GAAP approved method that will satisfy the IRS; the CPA doing your financial statement; and the external reporting requirments. As management accountants, they fail to see the valuable interal uses of overhead allocation and fail to find the strategic value of overhead allocations. Here is an example of something I see all the time. For the sake of argument, lets say that there are just 2 companies in our area. We work for DumbCo, and the name of our competition is SmartCo. This year there will be 4 jobs let out to bid, but both companies only have the capacity to do 2 jobs. The following table lists the bids in Year 1. Both companies are nearly identical in cost structure, so it's no surprise that in year 1 their bids are identical. Year 1 Bids | | DumbCo | SmartCo | | HardJob1 | $1,000,000 | $1,000,000 | | HardJob2 | $1,000,000 | $1,000,000 | | EasyJob1 | $1,000,000 | $1,000,000 | | EasyJob2 | $1,000,000 | $1,000,000 |
Our bidding department prepared the following summary of the bids. On paper both bids look profitable, and everybody at DumbCo is happy because we have work. Year 1 Estimated Gross Profit | | HardJob1 | EasyJob1 | Total | | Contract Price | $1,000,000 | $1,000,000 | $2,000,000 | | Direct Costs | $500,000 | $500,000 | $1,000,000 | | Applied Overhead | $450,000 | $450,000 | $900,000 | | Gross Profit | $50,000 | $50,000 | $100,000 |
Unfortunately, bidding departments in construction companies rarely know much about overhead allocation and it's pitfalls. Everything goes exactly as planned. We're on time and on budget. Since our accounting department uses the same incorrect overhead allocation, they get the same result as the bidding department. Year 1 Actual (According to Accounting Department) | | HardJob1 | EasyJob1 | Total | | Contract Price | $1,000,000 | $1,000,000 | $2,000,000 | | Direct Costs | $500,000 | $500,000 | $1,000,000 | | Applied Overhead | $450,000 | $450,000 | $900,000 | | Gross Profit | $50,000 | $50,000 | $100,000 |
Unfortunately, nobody stopped to realize that our overhead allocation method didn't mirror reality. In reality, we were spending 66% of our time supporting the very difficult "HardJob1," and only 33% of our time supporting "EasyJob1." If we would have been more accurate with our overhead allocations, we would have seen that reality was much different than what our accounting department told us. Here's what our financial should have looked like: Year 1 Actual (Based on Correct Overhead Allocation) | | HardJob1 | EasyJob1 | Total | | Contract Price | $1,000,000 | $1,000,000 | $2,000,000 | | Direct Costs | $500,000 | $500,000 | $1,000,000 | | Applied Overhead | $600,000 | $300,000 | $900,000 | | Gross Profit | ($100,000) | $200,000 | $100,000 |
As you can see, the improper overhead allocation didn't affect our Corporate Financial Statement. Our Gross Profit is the same with the improper overhead allocation as it is with the proper overhead allocation. So our external reporting will be fine. Our banker will have the correct information. Our CPA will be happy, because we've done everything according to GAAP. So our CPA is not likely to find this error, because our problem is in our job cost system. The Danger of Mis-Allocation Right now, you're saying to yourself, "who cares?" If it didn't affect our bottom line, our banker doesn't care, my CPA doesn't care, then it's no big deal. It is a big deal. To illustrate. Let's look at year 2. In Year 2, again there are 4 jobs to bid. We use the same bidding strategy as in year 1. SmartCo however has learned from Year 1 and they've changed their bids. They bid significantly more money on the HardJobs, and a little less money on the small jobs. We laugh at them because they're so dumb. We beat them by $200,000 on the HardJobs, so we think they're dumb. They also bid $50,000 less on the EasyJobs. Again we think they're being foolish by giving away money. Here's what the bids looked like: Year 2 Bids | | DumbCo | SmartCo | | HardJob3 | $1,000,000 | $1,200,000 | | HardJob4 | $1,000,000 | $1,200,000 | | EasyJob3 | $1,000,000 | $950,000 | | EasyJob4 | $1,000,000 | $950,000 |
It's obvious what will happen in the bid market. We get both of the hard jobs, and SmartCo gets both of the easy jobs. As the year progresses, we find out that we're understaffed and unable to deal with the complexity of both HardJobs, so we're forced to hire more overhead people to finish the jobs. Here's what our financial statement looks like: DumbCo Year 2 Actual Income Statment | | HardJob3 | HardJob4 | Total | | Contract Price | $1,000,000 | $1,000,000 | $2,000,000 | | Direct Costs | $500,000 | $500,000 | $1,000,000 | | Applied Overhead | $600,000 | $600,000 | $1,200,000 | | Gross Profit | ($100,000) | ($100,000) | ($200,000) |
Unfortunately our balance sheet was not strong enough to deal with our Year 2 losses, so DumbCo goes out of business. On the other hand, lets look at the income statement from our competitor, SmartCo. SmartCo Year 2 Actual Income Statment | | HardJob3 | HardJob4 | Total | | Contract Price | $950,000 | $950,000 | $1,900,000 | | Direct Costs | $500,000 | $500,000 | $1,000,000 | | Applied Overhead | $300,000 | $300,000 | $600,000 | | Gross Profit | $150,000 | $150,000 | $300,000 |
Because SmartCo has the correct overhead rate and gets awarded the most profitable jobs, they have the best fiscal year ever. Don't Let This Happen To You I've seen SmartCo's and I've seen DumbCo's. Unfortunately, there are way more DumbCo's out there than there are SmartCo's. Too many companies don't know how to apply overhead correctly, and they don't understand the strategic uses of overhead allocation. Overhead allocation is not easy. It's part science, and it's part art. It helps if you've been involved in a lot of different businesses and a lot of different industries. It also helps to know when you should use different overhead rates for external reporting and internal reporting. Part of the art of overhead allocation is knowing how complex the calculation should be - too simple and you're in trouble, but too difficult and nobody will comply. I would love to discuss your overhead calculations with you. You can e-mail me at John@ControllersAdvice.Com, or call me at 253-846-2804. John Wheeler | |