Overhead Expenses and General and Administrative Expenses
Participants:
Sally- Intern
Dominic- CEO of SolarCal
Luke- Head of Productions
Jake- Head of Accounting/Finance
Melissa- Head of Government Contracting
Dominic: Good morning Sally! Good to see you again. I hope you had a productive week with Luke as you assisted him with his special project.
Sally: Hello Dominic! Last week was very productive indeed. Luke went over a lot of the fundamentals involving direct costs and I really got a firsthand look at the project he was working on. I left Luke’s office with a really good understanding of the key concepts he went over with me.
Dominic: I’m glad you feel that way! I’m sure that the newfound knowledge will come in handy with future projects I assign you to work on. I’m pretty excited to see what Luke comes up with when I go over his project plan. I’m happy to hear he was a valuable resource for you during your time in his department.
Sally: I’m ready to learn more about these various government contracting concepts. What should I expect for this week?
Dominic: I like your enthusiasm! This week you will be working with me; I have a project that needs to be worked on, and I thought it would be beneficial if you worked alongside me this week.
Sally: That is fantastic! I’m ready to get started.
Dominic: The project we will be working on will be dealing with indirect costs. With that being said, I’d like to get you up to speed by going over some key concepts dealing with these indirect costs. Based on your schooling, do you recall anything about indirect costs?
Sally: Yes, I actually do! I recall that an indirect cost is any cost not directly identified with a single, final cost objective, but identified with two or more cost objectives or an intermediate cost objective. I also remember learning that indirect costs can be accumulated by logical cost groupings.
Dominic: That is great that you’ve heard of this term before, this overview may be easier than I thought.
It is also important to note that overhead and general and administrative are two categories of indirect expenses. There are several small companies, like ours, that have indirect costs that cannot be identified with various contract jobs, whether they are government or private.
Sally: Is this why you put these various indirect costs into overhead and general and administrative cost categories?
Dominic: You are absolutely correct! But keep in mind that the government agrees that one overhead account is enough in such situations.
Sally: That is great to know! I also hear a lot about the size of our overhead expenses during our weekly update meetings. Is this something you monitor closely?
Dominic: We absolutely monitor our overhead expenses. I believe that good management is always properly concerned with the close control of overhead costs. For obvious reasons, overhead costs should not become too large. Keep in mind that our company increased its overhead costs when we purchased all of the modern equipment and other technical advances to our assembly process, such as higher quality supervision.
Sally: Why did you elect to raise your overhead costs? Couldn’t you have continued using the equipment that was being currently used?
Dominic: That could have been an option for us. However, if we continued using the outdated equipment it would have driven up our direct costs in the process. The trick is to control the overhead to achieve effective and efficient operations. At our company some of our overhead costs include:
Indirect labor;
Costs associated with labor;
Indirect Supplies; and
Fixed Charges.
Sally: That is very interesting! So, it seems that by modernizing your equipment it saved you money in the long run. Is this correct?
Dominic: You are quite right! When you factor in tax deductions, we ended up with a net savings of eighteen percent by modernizing our equipment.
Sally: That is quite a savings! I can definitely see why you chose to modernize your equipment.
Dominic: Let’s now talk about the methods of allocation. There are many ways to allocate overhead costs, but some basic principles apply to these methods. One of these methods deals with the overhead costs being allocated based on the total overhead cost for a year. Sally, do you know of any other methods for allocation?
Sally: I recall that there are two more methods that can be used. I know that overhead costs can be allocated based on estimates of the total overhead costs for the present accounting year. I also remember the estimated overhead costs can be divided by a factor called the basis of allocation.
Dominic: Very good Sally, you properly identified two other methods for allocation. Let me tell you about one more method that can be used as well. The direct labor cost method is another widely used method and works better than a base of direct labor hours when there is a wide range of direct labor pay rates. This method can also be used in a highly mechanized production operation where material cost is the major part and labor costs are minor.
Sally: I never knew about that method until now. I will definitely keep this methodology in mind for future projects I may encounter.
Dominic: I’m glad I shared that information with you; this method does come in handy for certain situations. Take notice that the allocation of overhead is nothing more than a way to divide overhead cost. However, a proper overhead rate is essential for a company to determine its costs and, ultimately, the price to charge for each of its products or services.
Sally: What happens if the overhead rate is set too low?
Dominic: Great question! When the overhead rate is set too low, the company will not get enough money from its customers to meet its actual overhead cost. This shortfall can happen for a variety of reasons including the estimate of overhead costs being lower than the actual overhead. On the flipside, if the overhead rate is set too high, the company will include more for overhead in its charges than is needed to meet the actual overhead costs. The extra money received during the course of the year adds to the company’s profit. However, the chance of absorbing the exact amount of overhead by a series of many customer billings throughout the year is rare.
Sally: That makes a lot of sense now; your explanation definitely made things a lot clearer. Aren’t there also overhead accounts that often show line items for the cost of holidays, vacation time, and sick time?
Dominic: Right you are! These line items are referred to by the Cost Accounting Standards as compensated personal absences. It requires that these items be segregated into an indirect cost account and allocated to all cost objectives. Keep in mind that when a firm projects overhead costs for the current year, it estimates the hours that employees will be out for the holidays, paid vacations, and sick leave.
Sally: I thought I was on to something but am glad I confirmed this with you. I did have a question about overhead analyses that I was hoping you could clear up for me. I know that once the government awards a firm-fixed-price contract to a company, it is committed to pay that price. I recall that since the overhead cost is part of the price, the government analysis of the overhead rate must be as precise as is possible under the circumstances. Am I correct with my understanding of this?
Dominic: You are correct Sally. Let me just add a couple things to your response and see if this ties up any loose ends for you. If you recall, the purpose of the analysis is to come up with a bottom line price that is reasonable, remembering that we can never predict future costs with total accuracy. We will want to use a cost reimbursement contract for this process because the costs of performance cannot be predicted with high accuracy. Keep in mind as well that the government is protected by cost reimbursement contracts because they are finally settled based on actual costs incurred.
Sally: I’m glad we are on the same page and you absolutely filled in some gaps I had with my understanding of this subject.
Dominic: Let’s now turn our attention to General and Administrative, or G&A Expenses. Have you heard of this concept before Sally and if so, can you provide me with an explanation?
Sally: I actually have heard about this topic while I was in school. I recall that the Cost Accounting Standards define general and administrative expenses as any management, financial, or other expense which is incurred by, or allocated to, a business unit. It is to the best of my knowledge that general and administrative expenses are also a type of indirect cost one would probably see any time a pricing proposal from a company with several operating divisions is received.
Dominic: Very good Sally, I am impressed! You must have been really paying attention in that class. You are correct though; these expenses are the indirect costs incurred at the top level of a larger company. A company like that would have overhead cost pools for each of its operating divisions. In addition, the company would also have top level costs for operating its corporate headquarters. These top level costs involve general and administrative costs and represent a layer of indirect costs in addition to overhead.
Sally: Let me share one more thing with you, Dominic. I remember that the government views general and administrative expenses as a cost of doing business. It seems that the government is willing to pay a fair share of the firm’s general and administrative expense, subject to certain rules. I recall that the firm must allocate G&A expenses by acceptable methods, and the allocation base must be the same as that used for other customers.
Dominic: Great work and thank you for sharing that with me, you brought up a valuable concept for discussion. Let me expand on your response a little bit and talk about the allocation of these G&A expenses. The accounting profession considers allocation of General and Administrative expense to be a very difficult area. Even though it is a category of indirect cost, it does not behave in the same way as overhead costs. Make a note that General and Administrative expenses are different from other indirect costs. Many of them are more fixed in nature than overhead costs. They do not vary as much with changes in business volume and sometimes, they do not vary at all. Sally, since you seem to have a good grasp of these concepts, do you recall anything about the three methods for allocating General and Administrative costs?
Sally: I sure do and would be delighted to share this with you! The first method is referred to as total cost input, which should include all significant costs representing the total business activity. The second method would be value added, which may be used if the inclusion of materials and subcontract costs would significantly distort the allocation of the General and Administrative expense pools. The final method I remember is the single element cost input, which may be appropriate for a company that primarily produces labor intensive services, with very small material and subcontracted expenses.
Dominic: Excellent job recalling those three methods of allocation. You have done great, and your knowledge base is vast in this subject area.
Before we get ready for our weekly review, I would like for you to go through a review activity I have prepared to help you better grasp some of the concepts we covered this week.
Dominic: Indirect Costs is any cost not directly identified with a single, final cost objective, but identified with two or more cost objectives or an intermediate cost objective. Secondly, indirect costs shall be accumulated by logical cost groupings with due consideration of the reasons for incurring such costs.
Dominic: Overhead Expenses must bemonitored to ensure that overhead costs don’t become too large. However, a company also increases its overhead costs when it buys modern equipment and makes other technical advances, such as higher quality supervision. It is also important to note that these expenses can have low overhead costs by continuing the use of outdated equipment and facilities, thus driving up the direct costs in the process. The trick is to control the overhead to achieve effective and efficient operations.
Dominic: Importance of Overhead Analysis deals with thegovernment awarding a firm-fixed-price contract and requiring the end user to be committed to pay that price. Because overhead cost is part of the price, the government analysis of the overhead rate must be as precise as is possible under the circumstances. The purpose of the analysis is to come up with a bottom line price that is reasonable, remembering that we can never predict future costs with total accuracy.
Dominic: General and Administrative Expenses are defined as any management, financial, and other expense which is incurred by, or allocated to, a business unit and which is for the general management and administration of the business unit as whole. General and administrative expenses are also a type of indirect cost you will probably see any time you get a pricing proposal from a company with several operating divisions.
Dominic: Great work on the review materials. You did excellent and I think you really have a solid foundation for the concepts we discussed this week.
I would now like to summarize what we went over this week to fill in any gaps you may have had. Please feel free to add on to anything I say as we go through.
Sally, do you want to begin this review?
Sally: Sure thing! First, we learned that an indirect cost is any cost not directly identified with a single, final cost objective, but identified with two or more cost objectives or an intermediate cost objective. I learned that overhead and general and administrative are the two categories of indirect expenses.
Dominic: I then talked about some methods that can be used to allocate overhead costs. I also went over some basic principles that applied to the methods we covered.
Sally: After that, we talked about conducting an analysis for the overhead rate. We also talked about some of the overhead costs, like vacation, holiday, and sick pays which I learned was referred to as compensated personal absences.
Dominic: I also stressed the importance of carefully analyzing overhead costs. I told you to keep in mind that once the government awards a firm-fixed-price contract, it is committed to pay that price. I also explained that the overhead cost is part of the price and the government analysis of the overhead rate must be as precise as is possible under certain circumstances.
Sally: I definitely took notes when we went over that section, there was a lot of information I thought was important. I then learned that the General and Administrative Expenses are any management, financial, or other expenses which are incurred by, or allocated to, a business unit. I also noted that the government views general and administrative expenses as a cost of doing business and is willing to pay a fair share of the firm’s general and administrative expense, subject to certain rules.
Dominic: Glad to see you were paying attention when we went over that concept! We continued our discussion by addressing the allocation of General and Administrative expenses. We talked about this area being very difficult since it is a category of indirect cost, yet does not behave in the same way as overhead costs.
Sally: I recall the last thing we went over were the three allocation methods of General and Administrative expenses. I went over these three methods with you and determined that the methods consisted of: total cost input, value added, and single element cost input.
Dominic: Good work with the review Sally. You did really well this week with the concepts we went over.
Sally: Thank you Dominic! This review was very helpful, and I feel that I have really grasped the key concepts discussed this week. I believe I am very confident assisting you with future projects!
Dominic: I would gladly have your assistance on other projects; you have done a great job thus far during your internship. I look forward to working with you again.
Until we meet again don’t forget to complete your weekly discussion questions based on the key concepts we covered this week.
Have a good rest of the day and I will see you next week!
