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.

Overhead classification and allocation decisions are typically made by the company taking into account internal factors, such as how the information will be used to manage the business and how much it will cost to track and allocate the overhead costs. In practice, however, overhead allocations from a company's accounting system often serve as the basis for compiling damages claims by default because they are relatively easy to obtain. Because these internal allocations were most likely not designed nor intended for measuring damages, plaintiffs and defendants should critically evaluate whether they capture a meaningful and economically rational measure of the harm caused by the breach. Closer examination and a better understanding of overhead costs can lead to substantial differences in the amount of damages awarded.

Analyzing a claim for overhead damages begins with developing a clear understanding of the nature and characteristics of the overhead costs that are being allocated. Once the different types of costs are identified with a reasonable degree of clarity, an evaluation must be performed to determine whether or not there is a sufficient relationship between the overhead costs and the direct costs claimed as damages.

A cornerstone principle of overhead cost allocation methodology is the cause-and-effect relationship. Specifically, the methodology chosen to distribute overhead costs to projects should reflect a correlation between the level of activity of a variable (such as labor hours, square footage, number of pieces handled) and the amount of cost incurred. The variable that causes overhead to be incurred is often referred to as the "cost driver" of overhead. An allocation methodology reflecting an appropriate cause-and-effect relationship is demonstrated by a predictable change in the amount of overhead incurred in response to a particular change in the level of activity of the cost driver. For example, if gasoline was considered an overhead cost, miles traveled would be a good cost driver to use because consumption of gasoline varies closely with distance.

An allocation methodology with a weak cause-and-effect relationship has the potential to produce disproportionate overhead amounts and may not be appropriate for measuring the economic harm caused by a breach of contract. For example, if gasoline costs were allocated according to the number of packages per truck instead of miles traveled, the resulting allocation may distribute a disproportionately high amount of cost to a project that shipped packages across town as compared with another project whose shipment traveled across country.

To arrive at a fair quantification of the amount of overhead associated with any particular project, careful attention must be paid to verifying that the chosen allocation methodology does not artificially drive too much or too little overhead to the project in question. A "one-size-fits- all" approach to choosing an allocation methodology often results in a quantum of overhead costs that has little or no relevance to the effort or demands of the breach activities at issue. More effective cost allocation systems employ multiple cost drivers for different types of overhead costs. For example, a company could use miles traveled to allocate gasoline costs and number of packages per truck to allocate loading dock labor costs. Tailoring allocation methodologies to particular types of overhead costs results in a better fit with respect to causation.

To avoid misleading and disproportionate allocations of overhead, manual adjustments to allocation methodologies are sometimes necessary to compensate for factors that would otherwise lead to results that are inconsistent with the economic reality of the breach. Such manual adjustments could involve excluding certain factors from the allocation calculation if their inclusion would otherwise produce a result that does not reflect a cause-and-effect relationship. For example, third-party contract costs are often excluded from cost allocation calculations because the amounts paid to outsource an activity often have little to do with internal corporate administrative costs that may be captured in overhead.

Although the inclusion of some measure of overhead costs in damages may be necessary to compensate the plaintiff fairly, it is clear that thoughtful consideration is required to reach an economically rational award. Plaintiffs and defendants should carefully evaluate any circumstance in which damages might include an element of overhead to determine whether the amounts at issue reflect actual costs or simply the product of a formulaic accounting exercise.

Keywords: litigation, expert witnesses, overhead costs, breach-of-contract case, allocation methodology, damages

Jonathan Couchman, CPA, CFF, is a managing director with Veris Consulting, Inc., in Reston, Virginia.

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