Posts Tagged Overhead
Overhead Rates, Part 2
In Part 1 of this series, I gave an overview of the different categories of overhead rates. In Part 2, I’ll show you not only how to calculate overhead rates, but some of the strange lingo that’s part of the process.
The two factors that determine overhead rates are the base, sometimes called the burdenable base or prime dollars, and the expense, or overhead. The overhead rate is merely the ratio between your expenses and your base.
The Base
The base, or prime dollars, is comprised of several categories, or “pools“:
- Direct Labor - employees’ wages/salaries that work directly on specific contracts. This can be further broken down into separate pools for Engineering, Manufacturing, Field Service, etc.
- Direct Material - raw material or parts purchased for specific contracts
- Subcontract Material - larger assemblies that exceed a certain dollar threshold
- Travel - travel and lodging directly related to specific contracts
- Other Direct Cost - items that don’t fit into any of the other categories
Overhead Expense
Sometimes referred to as “burdens“, overhead includes expenses not directly related to specific contracts, such as employee medical benefits, rent, electricity, etc. Expenses are categorized by pool. For instance, the maintenance expense for a drill press would be allocated to the Manufacturing pool, while the calibration expense for an oscilloscope would be classified as an Engineering expense.
The Calculation
The purpose of calculating the overhead rate is to see what the ratio is between your direct costs and your expenses. This makes it easier to spot trends, as both sides of the ratio vary year to year.
Here’s an example. Company A projects direct Engineering labor of $10 million, and Engineering-related expenses of $15 million for 2009. This works out to an Engineering overhead rate of 150%:
15,000,000 / 10,000,000 = 1.5 x 100 = 150%
Company B, on the other hand, has direct Engineering labor of $8 million, and Engineering overhead expense of $11 million:
11,000,000 / 8,000,000 = 1.375 x 100 = 137.5%
Company B has done a better job of controlling its overhead expense, and is better positioned to win future contracts from the government. Of course, this is a simplistic view, and the other overhead pools (material, travel, etc.) would have to be taken into account.
How can we apply this to personal finance? You could use your wages as the base, and calculate a year-to-year overhead rate using your expenses. You’d be able to spot trends over time. Expenses can be measured as a percentage of your income.
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Overhead Rates, Part 1
If you’ve ever worked for a defense contractor, you’re probably well acquainted with overhead rates. For those of you who haven’t had the pleasure of dealing with Uncle Sam on a daily basis, let me give you a brief rundown. They come in many flavors, such as:
Actual Rates
These are, as you would imagine, your actual costs. This information comes right off of your general ledger.
Projected Rates
This type of overhead rate is generally developed for an overhead rate submission to the government, or for a year-end projection. It takes into account any factors that have not been captured in your actual costs to this point. An example would be a higher than expected medical benefits expense, or an unfunded pension payment. Typically, this leads to:
Forward Pricing Rates
After projecting your overhead expenses, you’re compelled to disclose to the government any new intelligence that you’ve gathered. The vehicle used is called a Forward Pricing Rate Proposal. After this proposal is submitted, you negotiate with the government. If all goes well, the result should be a Forward Pricing Rate Agreement, or FPRA. The FPRA allows you to bid on jobs using your most current projected rates. It also establishes the billing rates for cost-type contracts.
Billing Rates
Billing rates may come from several sources: the FPRA, which covers most of your cost-type and fixed-price contracts; an FPRA which has been discounted based on an agreement with the government; and lastly, rates that have been negotiated into a specific contract, such as a time and material-type contract. Rates are established for billing time (labor hours) and material (purchased parts) by each category, such as manufacturing, engineering, or administration.
That’s a basic overview of the different categories of overhead rates. In the second part of this series, we’ll take a look at how overhead rates are calculated.
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