Overhead allocation is one of those tasks that can either make your financial reporting a breeze or a bit of a nightmare, depending on how you approach it.

Overhead costs—think administrative salaries, office rent, and equipment maintenance—are those essential but indirect expenses that keep a business running. Accurately allocating these costs is important for project-based businesses like construction firms, architecture firms, and consultancies.

In this blog, I’ll share what overhead allocation is, the different methods available, and, most importantly, how you can set it up in one of the world’s most popular project management software – Deltek Vantagepoint.

What is Overhead Allocation?

Overhead allocation is essentially the process of distributing your indirect costs across various cost objects—such as projects, departments, or products. Indirect costs are expenses that cannot be directly attributed to a specific cost object, but are necessary for the overall operations of the company. These can include rent, utilities, administrative salaries, and other general overhead expenses.

Accurately allocating overhead costs, meaning any expenses that are not directly related to the production of goods or services, makes it so that your financial reports reflect the true cost of doing business. Overhead costs are significant. In fact in construction, the average overhead percentage is around 10%.

For example, let’s say your business incurs $100,000 in overhead costs during a given period. Without properly allocating these costs, you could end up underpricing your projects, leading to a nasty surprise when the bills start piling up.

Example of Overhead Allocation

Here’s a quick example that really illustrates the importance of overhead allocation. Imagine you’re running two projects: Project A and Project B. You’ve determined that your total overhead costs amount to $200,000 for the quarter. Now, let’s say Project A uses 70% of your company’s total direct labor hours, while Project B uses the remaining 30%.

Using a direct labor hours method, you’d allocate $140,000 (70%) of the overhead costs to Project A and $60,000 (30%) to Project B. This approach makes it so that each project bears a fair share of the overhead costs, reflecting its use of company resources.

What are the Methods of Allocating Overhead?

There are various methods for allocating overhead costs, each with its own benefits and limitations. Let’s take a look at some of the most common methods that companies use today:

Direct Labor

Allocating overhead based on direct labor hours or costs is one of the most straightforward and commonly used methods, especially in labor-intensive industries like consulting, construction, and professional services. This method assigns overhead costs in proportion to the direct labor hours worked on each project.

Machine Hours

In industries where machinery plays a central role in production—think manufacturing, construction, and heavy engineering—allocating overhead based on machine hours can provide a more accurate reflection of costs. This method allocates overhead based on the number of hours that machines are in operation for a particular project.

Square Footage

Square footage allocation is particularly useful for businesses where physical space is a significant overhead cost, such as those in real estate, warehousing, or large-scale office environments. This method allocates overhead costs based on the amount of space each department, project, or product occupies.

Project-Based

Project-based overhead allocation is perfect for businesses that need to keep a close eye on project-specific costs, such as architecture firms, construction companies, or consulting firms. With this method, overhead is allocated directly to specific projects based on predefined criteria, such as the project’s budget, duration, or complexity.

Percentage of Direct Labor Hours

This method is a variation of the direct labor method, where overhead is allocated as a percentage of direct labor hours or costs. It’s especially useful in industries where projects or departments vary significantly in size and scope, but where labor remains a central cost driver. This method allows for more flexibility and can be adjusted to reflect the unique characteristics of each project or department.

Choosing the Right Method

When it comes to allocating overhead, there is no one-size-fits-all solution. The method you choose will depend on your specific business needs and industry. It’s important to carefully evaluate the different methods and their pros and cons before deciding on the best approach for your company.

For example, if your business has a large number of small projects with varying budgets and durations, using the percentage of direct labor hours or costs method may be more suitable. On the other hand, if your business mainly works on larger projects with fixed budgets and longer durations, the direct labor or direct cost method may be a better fit.

Benefits and Limitations of Overhead Allocation

Like most things in project management, it comes with its own set of benefits and challenges and isn’t an end-all-be-all solution. Here are some of the benefits and some of the limitations to consider when using overhead allocation:

Benefits of Overhead Allocation

Fairly Distribute Costs

One of the primary advantages of overhead allocation is its ability to distribute costs fairly across different projects or departments. In any business, there are shared resources—like office space, administrative staff, or utility bills—that don’t directly tie to a specific project but are essential to all. By allocating these overhead costs appropriately, you ensure that no single project is unfairly burdened or, conversely, benefiting from shared resources without bearing the associated costs.

Avoid Cost Distortions

Accurate overhead allocation plays an important role in preventing cost distortions. When overhead costs are not allocated correctly, it can lead to misleading cost data, which in turn affects everything from pricing strategies to budget planning. For example, if a project is under-allocated with overhead, it might appear more profitable on paper than it actually is. Conversely, over-allocating overhead to a project can make it seem less profitable, potentially leading to misguided decisions like cutting resources or even abandoning the project.

Incorporate Full Product Costs

Another significant benefit of overhead allocation is that it allows you to incorporate the full costs of your products or services into your pricing models. When you only account for direct costs—like materials and direct labor—you might miss out on the myriad of indirect costs that contribute to the final product. These indirect costs, or overhead, are vital to maintaining your operations but can easily be overlooked in pricing strategies.

By incorporating overhead into your product or service pricing, you can make sure that you’re not undercharging your clients. This comprehensive approach to cost management helps maintain healthy profit margins and ensures that all aspects of production, from direct labor to administrative support, are factored into your pricing decisions. This is especially important in competitive markets where undercharging can lead to a race to the bottom, while overcharging can price you out of potential deals.

Limitations of Overhead Allocation

Just like there are benefits to incorporating overhead costs into your pricing, there are also limitations that must be considered. Let’s take a look at them:

Inaccurate Allocation

While overhead allocation is important, it’s not foolproof. If the allocation process isn’t handled correctly, it can lead to inaccuracies that distort your financial reporting. For example, choosing the wrong allocation base—such as using machine hours in a labor-intensive industry—can result in a misallocation of costs. This inaccuracy can mislead decision-makers, leading to poor strategic decisions that could harm your business in the long run.

Moreover, even with the right allocation base, the complexity of certain projects or departments might lead to challenges in capturing all relevant overhead costs accurately. This is where the importance of having the right tools and expertise comes into play. It’s crucial to regularly review and adjust your overhead allocation methods to make sure they remain aligned with your business’s operations and cost structures.

Increased Accounting Complexity

Allocating overhead isn’t as simple as applying a flat rate across all projects—it adds a layer of complexity to your accounting processes. This complexity can be daunting, especially for businesses that are new to detailed cost accounting or lack sophisticated accounting systems.

Additionally, as your business grows and diversifies, the overhead allocation process can become even more complex. Managing overhead allocation for a multi-department or multi-project business often involves dealing with varying cost drivers, fluctuating overhead costs, and the need for continuous adjustments. Without the right tools and processes, this complexity can lead to errors, inefficiencies, and, ultimately, misinformed business decisions.

In my experience, while the complexity of overhead allocation can be intimidating, the long-term benefits—such as fair cost distribution, accurate profitability analysis, and comprehensive pricing strategies—far outweigh the challenges. With the right approach, overhead allocation becomes a powerful tool in your cost management arsenal, helping you steer your business toward sustained profitability and growth.

Technology’s Role in Overhead Allocation

Luckily, technology has made the process of overhead allocation much more manageable and accurate. With advanced software programs and digital tools, businesses can automate the tedious task of allocating overhead costs and gain real-time insights into their profitability.

One such tool is Deltek Vantagepoint, which is the predecessor of Deltek Vision. With Vantagepoint, you can automate the allocation process, reducing the risk of errors and saving valuable time. The software allows you to set up your overhead allocation methods in a way that best suits your business, whether it’s by direct labor costs, machine hours, or another method.

Deltek Vantagepoint: How to Enter Overhead Allocation Settings in Deltek Vantagepoint

Deltek Vantagepoint’s interface is quite intuitive, especially when setting up overhead allocation. Here’s a step-by-step guide of how to enter overhead allocation in Vantagepoint:

1. Set Up Overhead Parameters:
   • Head over to Settings > Accounting > Overhead Allocation in Deltek Vantagepoint.
   • Here, you can define your overhead parameters. This includes selecting your overhead allocation method and setting the total overhead costs you want to allocate.
2. Choose an Allocation Method:
   • Deltek Vantagepoint lets you choose between different methods like proration (which distributes costs based on a ratio, such as direct labor hours) or assignment (where costs are directly assigned to specific cost objects).
3. Decide on Allocation Scope:
   • You can choose to allocate overhead on a company-wide basis or by organization. This flexibility is particularly useful if you have multiple departments or divisions.
4. Run the Overhead Allocation Process:
   • Once everything is set up, you can run the overhead allocation process. Alternatively, you can close a period in Vantagepoint, and the software will automatically calculate and allocate overhead costs based on your settings.

Getting these settings right in Deltek Vantagepoint can save you a lot of headaches down the line, making sure that your financials accurately reflect your business’s costs.

Key Takeaways

• Overhead allocation is all about spreading indirect costs like office rent or administrative salaries across your projects or departments.
• Deltek Vantagepoint offers multiple methods for allocating overhead, including direct labor and machine hours, which can be tailored to your needs.
• Setting up overhead allocation in Deltek Vantagepoint is straightforward, and once you get it right, it will make your financial reporting far more accurate and insightful.

Conclusion on Overhead Allocation

Overhead allocation might seem like something that might be hard to take on, but with the right tools, it becomes much more manageable. Deltek Vantagepoint and Vantagepoint CRM offer a user-friendly yet powerful way to handle this aspect of cost accounting, allowing you to allocate overhead efficiently and accurately.

Whether you’re a seasoned project manager or new to the world of cost accounting, understanding and using overhead allocation will help you better manage your business’s financial health. Good luck!