How to Allocate Overhead Expenses to Other Classes
How to Allocate Overhead Expenses to Other Classes in Quickbooks
By Peggy Seville, Certified QuickBooks ProAdvisor November 10, 2017
You’ve been using the Class field in Quickbooks to track different areas of your business. This field is used for tracking different profit centres such as Divisions, Product Lines, Programs, Projects, Events, and more. Not sure what the Class field is? Click here to read more about Classes.
It’s great that your business uses the Class field to run a Profit & Loss by Class. You are already getting some excellent information about your business so you can manage your business better, but are you applying your overhead costs to those different business areas?
Why Do I need to Allocate my Overhead?
This is an important step that often gets missed. You may think you’re making money in a certain area of your business until you apply your overhead costs and get a big surprise. You might find out that some Classes are supporting other Classes. Maybe your company would be better off if you cut out that area of your business!
When do I Allocate Overhead?
At the end of your reporting period, think about how your overhead or common administrative costs should be applied to the other Classes. This could happen monthly, quarterly or annually. I recommend starting with at least quarterly first. If you choose annually, by the time you get this information it may be too late to make adjustments.
How Much Overhead do I Apply to Each Class?
Pick a method that is most appropriate for your business to determine the ratio. Here are some ways that overhead can be applied.
• Percent of Gross Sales of each Class (less meaningful)
• Percent of Gross Profit of each Class (Income less Cost of Sales)
• Net Profit of Each Class (Income less Cost of Sales less Expenses)
• Hours spent in each Class
• Payroll costs in each Class
For example, there is an area of your business which is consuming more of your staff’s time than others, so you use the Percent of Hours method to allocate overhead. Your Gross Profit ratio of this Class is 20%. When you compile the hours spent (from your time tracking software), you realize that the percent of hours spent was 35%. Now, 35% of payroll costs should be applied to that Class instead of 20%. The profit picture of this Class is suddenly changed and might no longer be profitable.
Imagine if you had just continued along in your business without figuring this out. It would be a continued drain right off the bottom line. Not taking the time to apply administrative or overhead costs to your other Classes can be a costly oversight.
How do I apply the Administrative Costs to my other Classes?
You can make a journal entry to remove the income or expense from the Admin class and apply it to the same accounts with the appropriate classes. The journal entry would appear like this:
Job Supplies Dr 20,000 Commercial
Job Supplies Dr 20,000 Residential
Job Supplies Cr 40,000 Overhead
Alternatively, you could export your Profit & Loss by Class into Excel and make the changes in a spreadsheet instead of your accounting system. If you are handy with Excel, you can apply a formula to make the allocations.
There are pros and cons of each method.
Of course, you could start in Excel and when you have picked a method and obtained your results, then you could enter the journal entry into Quickbooks.
Example of Overhead Allocation
For example, Joe runs growing a plumbing business and he has a small crew of 5 plumbers. He does some residential and commercial work. Recently, he has bid on some new construction jobs too and that has been going very well. His Classes in Quickbooks are:
• New Construction
When he runs his Profit & Loss by Class report, he can see that each division is operating well and making a profit. He is making a positive overall net profit which he would like to increase but finds satisfactory. He’s never applied his overhead costs to the other divisions before, but thought he would like to do it for this quarter to see how his New Construction division is really performing. Here is Joe’s Profit & Loss by Class before the allocation of overhead.
Joe has determined that the Percentage of Gross Profit for each Class is the best method. He decides to export his Profit & Loss by Class into Excel to make the allocations. After he applies the overhead to each division, his report now looks like this:
His New Construction division has only made $15,383 in its first year. It’s not that much but it’s only the first year and at least it’s making a profit. Then he realizes that he really had to bid low on those new construction jobs to get them since there were a lot of other companies bidding. Maybe he should use the % of Payroll Costs instead to allocate his overhead. Joe recalculates his overhead and now his Profit & Loss report by division looks like this:
This method may be more telling of the true performance of Joe’s New Construction division. It is now no longer profitable. The New Construction division has taken 14.9% of the total payroll costs but only produced 4.1% of his Gross Profit. The Gross Profit for this division is too low to be truly profitable. Now Joe has the information he needs to make some decisions about bidding on future jobs. He can set a minimum profitability objective on future new construction bids. If he has to bid lower than that to get the job, it’s better to just walk away.
Now we understand the importance of taking the extra step to apply administrative costs to your different business areas. You might be overlooking some critical information about your business and miss maximizing your profit. Making the right choice of allocation methods to use and playing around with different scenarios can highlight some important differences and change the profitability picture.
Want some assistance analyzing your Classes in Quickbooks and allocating overhead? We are here to help! Click here for more information.