February 21, 2013 Articles

For Young Lawyers: Deconstructing Overhead Costs

Understanding recovery and the allocation methodology in breach-of-contract cases.

By Jonathan Couchman

Many damages claims may include some measure of overhead or indirect costs, and these costs may form a substantial part of the entire damages claim. However, overhead often receives less attention than it deserves.

When quantifying damages in a breach-of-contract case, two important questions need to be answered. First, is recovery of overhead costs necessary to make the non-breaching party whole? Second, if recovery is determined to be appropriate, what amount of overhead will put the non-breaching party in the same position it would have been in absent the breach? The answer to these questions requires understanding what types of costs are included in overhead and deconstructing the allocation methodology.

Overhead costs are typically recorded in the aggregate and then distributed to various project accounts using an internally developed allocation methodology. As a result of this process, the direct costs of each project (costs that are specifically identifiable to the project, such as invoices and direct labor) become "loaded" or "burdened" with a portion of overhead costs that are not directly associated with any particular project. Both the types of costs that are included in overhead and the manner in which they are allocated to specific projects vary greatly between companies. This disparity in the practice of classifying and allocating overhead is not surprising because these issues are not covered by Generally Accepted Accounting Principles (GAAP). Moreover, overhead and its allocation to specific projects is not typically addressed by a company's external auditor in the course of auditing its financial statements.

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