Chart of Accounts
The key to managing a profitable Company starts with the Chart of Accounts. It should be designed specifically for your business to give you useful and accurate information that can be used to manage your Company.
The Chart of Accounts is a list in your accounting system that defines each class of items that are used in regard to money spent or received. Generally, you will have major classifications for Revenue, Cost of Goods (Direct / Variable Costs) and then Overhead (Fixed Expenses or Operating / Administrative Costs). Under each of the major classifications should be several sub classifications such as Direct Labor and materials in COG; with rent and administrative labor costs in Overhead (operating expenses). How these items are grouped is the key to having a meaningful P & L or Income Statement. How it is formatted enables you to calculate your Overhead Recovery Ratio and recover enough money to offset your Overhead expenses and get you to a break-even point.
As stated earlier, the Chart of Accounts will also give you information to help manage your company. The amount of detail will vary by the types of business. But the amount of detail will be essential in identifying “winners and losers.” Identifying profitable revenue streams versus those that are costing the Company money and may need to be tweaked or dropped altogether. Early analysis may be a key to righting your ship and creating smooth sailing ahead. The numbers in a properly set-up Chart of Accounts can also be used to plan future Budgets and consequently your capital expenditures.
Think of the Chart of Accounts as the instrument panel of a car or airplane. You can’t drive or fly without knowing your speed, direction, engine conditions, weather conditions, etc. It needs to give basic readings that can be put together in reports, ratios or percentages to help guide the Company. Unfortunately, most Charts of Accounts are set-up with very little or no thought given to Managerial Accounting or accounting designed for internal (management) use. Most (95%) of the Chart of Accounts are set up with only one thing in mind; your tax bill. They were set up by your accountant or bookkeeper for this purpose. They are not set up for you to use as a basis for actually managing your Company. For example, placing all payroll and benefits in one account in Overhead with no distinction between Direct Labor (labor actually doing the work) and administrative labor does not allow us to determine an accurate Overhead Recovery Ratio. That part of payroll for Direct Labor is considered a Cost of Goods (Direct Cost) whose burdened payroll and benefits should have been properly bid in the job. It would not be part of Overhead.
If we put all of our revenue into one lump sum how do we tell which part of the business is profitable? If we have different revenue streams or profit centers which costs are also associated with each? These need to be separated in the Cost of Goods; separate labor, materials and equipment costs related to producing that specific revenue stream.
How do you want the Chart of Accounts formatted? Do you have different revenue streams? Can you measure the profits for each? Can you determine if it is worth being in that business? Not how does your Accountant want it to be formatted. Be assured that he is getting the same information that he needs to prepare your taxes but you will be getting far more useful information.
Overhead Recovery Rate
Once we have properly identified those items that are Cost of Goods and Overhead, we then set-up or revise our Chart of Accounts accordingly. Remember, if it is not billable to a job or cannot be put in a bid; it is mostly likely Overhead. This will then provide us with the type of P & L or Income Statement that we can use to make calculations. We can then determine the Overhead Recovery Rate that needs to be used in our bidding and pricing in order to cover our Overhead costs.
Basically, one can figure that for every dollar spent on Cost of Goods Sold, an additional “$” amount (determined by the Overhead Recovery Rate) must be added to recover the OVERHEAD. This allows a consistent application to all jobs.
The Overhead Recovery Rate may be based on either actual historical financial data or upon projected budgetary figures. Both calculations should be made for comparative purposes. Given the importance of the Overhead Recovery Rate, Revenue and all costs, whether directly or indirectly related, should be continually monitored. Don’t forget; changes in the amount of the Cost of Goods will impact the Overhead Recovery Rate because, if sales decrease there will probably be less Cost of Goods over which to spread our recovery rate. Even though, Overhead expenses are primarily fixed and therefore revenue increases or decreases will have little direct impact on them, a downward trend in sales will raise the Overhead Recovery Rate needed because there will be less COG to spread them over.
It is crucial that Overhead be monitored not only as a percentage factor, but also in terms of dollars. An Overhead Recovery Rate, expressed in percentage terms, is reliable only if you achieve the targeted revenue and maintain the associated direct costs at the projected level on which the factor is based. You must become intimate with all aspects of overhead, including not only the estimated annual percentage factor, but what the annual overhead dollar amount breaks down to on a weekly, monthly, quarterly, and semiannual basis. The capture or recovery rate of overhead should be tracked on an ongoing basis. An Overhead Recovery Rate Is Never Fixed or Constant – It Is Continually Moving and Chang
| OVERHEAD (G & A OR FIXED EXPENSES) | |
| OVERHEAD RECOVERY RATE = | ———————————– |
| COST OF GOODS SOLD (VARIABLE) |
The formula above will give you your Overhead Recovery Rate that needs to be applied to recover your Overhead. In other words, dividing the Overhead by the Cost of Goods will give us the percentage that we need to apply to all of our Direct Costs in order to cover all of our Fixed Expenses or Overhead.
If we use an example of Overhead Costs of $245,000 and Cost of Goods of $529,000; we would divide $ 245,000 by $529,000 which equals .4642 or expressed as a percentage, 46.31%. The Overhead Recovery Rate would be: 47%. For our purpose, we will round up and use 1.50 as the rate. In other words, we must recover an additional 50% of Direct Costs. Or we need an additional 50 cents for every dollar of direct costs. (Remember this is not a percentage of sales, but a percentage of COST OF GOODS.) In other words, divide the Total General and Administrative Expense by the Total Cost of Goods Sold and the result will be the Overhead Rate, expressed as a percent.
In other words, once we have determined all of the direct costs in a job; labor, materials, equipment, we then must apply our Overhead Recovery rate of 50% in order to charge enough to recover all of our operating or administrative expenses.
At Cogent Analytics, we never stop looking for ways to improve your business and neither should you. So, check out some of our other posts for helpful business information:
