All,
I obviously do not have enough to do because I finally found the time to further examine a bothersome issue that has been sitting in the back of my head for some time. If anyone else also has not enough to do, please go though the discussion below, and tell me what you think. I really want to understand if and where I am wrong.
Also, I have attached a spreadsheet further demonstrating this discussion.
Premise: Due to the different ways accounting systems handle overtime hours for salaried people*, Overhead Rates are not directly comparable among firms. For the same reason, neither are Billing (Net Revenue) Multipliers, nor Chargeability (Utilization) Rates. (* Among other more minor things)
Therefore: Because the different accounting methods each comply with FAR standards, Overhead Rates, per se, cannot be used by contracting authorities in selection processes or negotiations.
It also demonstrates that states imposing 'capped' or 'one for all' overhead rates inadvertently (presumably) penalize some firms while benefiting other firms.
Assume an individual's weekly salary is $1,000, equal to a 'standard' hourly payroll cost per hour of $25 ($1,000 divided by 40 hours), and the firm has an overhead rate of 1.600.
If all 40 hours of that employee's time one week goes to an OH rate cost-plus contract, the firm gets to bill the client $2,600 (40 x $25 x 2.600), which is $1,000.00 for labor and $1,600 for OH, plus whatever is the allowed profit.
Now, say this person worked 50 hours that week. There are two acceptable accounting methods to handle the situation:
- Recalculate to get the average or 'effective' hourly pay rate for the person, or
- Use the 'standard' hourly rate constant and credit (reduce) the firm's overhead pool for the equivalent dollar value of the unpaid hours charged directly to the project.
Using the first method:
- The 'effective' rate becomes $20 ($1,000 divided by 50 hours) because salaried people do not get paid for overtime.
- Again, the firm still only gets to bill the client $2,600 (50 x $20 x 2.600), the same amount as if the person only worked 40 hours!
- Another way to understand this is to the view the calculation as follows:
(40 x $25 x 2.600) + (10 x $0 x 2.600) = $2,600
- [Additional note: The client essentially gets 10 hours of professional services for free, too!]
Using the second method is not any better.
- There is a <$250> payroll variance that reduces the firm's overhead cost
- This lowers the overhead rate to only 1.080, as follows:
$1,250.00 charged to Direct Labor (50 x $25), but only $1,350 left in OH ($1,600 - $250)
OH Rate = OH / Direct Labor = $1,350 / $1,250 = 1.080
- The firm still only gets to bill $2,600:
50 x $25 x 2.080 = $2,600
- [Additional note: Again, the client essentially gets 10 hours of professional services for free!]
Billing (Net Revenue) Multiplier Impact
Shown above is that, in either case, $2,600 can be billed for labor and overhead. For ease of example, assume profit is $400, so that Net Revenue is $3,000.
Using the first approach, 'effective' hourly rate, the Billing Multiplier (Net Revenue / Direct Salary) is:
$3,000 / $1,000 = 3.00
Using the 'standard' hourly rate, it is:
$3,000 / $1,250 = 2.40
Chargeability (Utilization) Rate Impact
Using the 'effective' hourly rate, the Chargeability Rate (Direct Salary / Total Salary) is:
$1,000 / $1,000 = 100%
Using the 'standard' hourly rate, it is:
$1,250 / $1,000 = 125%
These Impacts Offset Each Other in the Net (Payroll) Multiplier
The Net Multiplier actually is the Billing Multiplier times the Chargeability Rate:
(Net Revenue / Direct Salary) x (Direct Salary / Total Salary) = Net Revenue / Total Salary
Using the 'effective' hourly rate, the Net Multiplier is:
3.00 x 100% = 3.00
Using the 'standard' hourly rate, the Net Multiplier is:
2.40 x 125% = 3.00
Either way, there is no difference to the firm's bottomline, which is important to us, which needs to be understood by contracting officials.
Also, please note that the situation cannot be gotten around by working 'only' 40 hours on the project, and the 'other' 10 hours on non-billable types of work. The system must account for all 50 hours.
However, there are two ways (at least) firms avoid this happening:
- First, no overtime is allowed, and extra people are used on the project, as necessary, to meet deadlines.
- Second, firms doing significant amounts of public-sector cost-plus work may pay their people straight-time for all hours worked.
Either way, no hours are 'free' anymore; hours are billable at an unreduced rate.
Michael Webber
CFO/Principal
A/E Finance
Chicago, IL
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