Payroll: Overhead or Cost of Sales?
Was your first instinct ‘overhead’? If yes, you probably have the same answer as a lot of others. You probably read the title of this blog and immediately thought that payroll is an overhead cost and it’s perfectly understandable. Here’s why it could be both.
What are Overhead Costs?
These are costs that are incurred to operate the business and are not directly associated with a product or service (known as ‘Below the Line’). These are what I like to call ‘Support Activities”. There are 3 types of overhead costs:
Fixed – costs that are the same every month – examples include rent and insurance
Variable – costs that vary month to month – examples include office supplies and maintenance
Semi-Variable – costs that have a fixed and variable component – examples include natural gas utility where they may charge you a fixed cost per month plus usage cost
What is Cost of Goods Sold?
This is also known as Cost of Sales and these are costs that are directly associated with a product or service (known as ‘Above the Line’). These are what I like to call ‘Revenue Generating Activities”. These costs would fall under one of three categories of cost of sales/cost of goods sold:
Direct labour
Direct material
Direct overhead – I added ‘direct’ in front to show that it is different than overhead costs in the section above – for example, manufacturing plant rent
Example of what an overly simplified summary income statement looks like
An example of an overly simplified summary income statement
Where does Payroll fit into this?
Honestly, it depends, but most of the time, it would be both. Why? Logically, you would have employees that focus on:
Just the revenue-generating activities,
Just the support activities, or;
A combination of both
If you, as the business owner, focuses on just the revenue-generating activities, while you hire employees to take care of the support activities, then all the payroll (not including compensation for yourself) would be overhead. How likely is this? Probably not that likely. There’s only so much you can do yourself before you need help.
When I talk about payroll, that would include payroll burdens as well because those are costs incurred by the company when you have employees. It makes sense to include these costs in the correct category with your payroll cost.
Example #1 – Construction Company
Project managers and site supervisors help to directly manage and execute on the project (revenue generating) so their payroll costs should be allocated to Cost of Sales.
On the other hand, your IT or HR department helps to support the company and is not tied to any project so their payroll costs should be allocated to Overhead.
Your Accounts Payable specialist may fall under both if they also support the projects.
Example #2 – IT Company
In this situation, your IT department would most likely be considered revenue generating if the employees are providing these services to clients.
On the other hand, your accounting or HR department helps to support the company and is not tied to providing these services.
Why is it important to separate payroll between Cost of Sales and Overhead?
Payroll costs in any company is one of the largest expenses you will incur, even though this may vary from industry to industry. Why? It’s simple. You need people to help you execute on your business plan. You most likely can’t do everything by yourself and you probably don’t want to do everything yourself.
If all payroll costs are captured in Overhead, these expenses would be greatly overstated and your Gross Profit would be greatly overstated.
If all payroll costs are captured in Cost of Sales, you are overstating these costs and understating your Gross Profit.
If these are overstated or understated, how do you know how much profit you generated is truly from the sale of services or goods? And how do you know what is truly the overhead cost? How do you know what price to offer to clients? Yes, there’s no change to the bottom line but how do you do effective business planning without the visibility into the numbers?
How do you actually go about doing this?
First, do you allocate payroll costs to Overhead only? Or Cost of Sales only? Or do you split it between the two? If you have it set up so that it’s going to the correct categories, then you are all set.
Next, do you know which employees are participating in revenue generating activities and which are support? You should have a good idea on this.
Next, ask your accountant how the payroll is set up in your accounting software which can automatically allocate the payroll based on the task/job, employee set up, etc. or ask them to show you where payroll is shown on the income statement.
Lastly, if your company uses jobs/projects/tasks, it might be a good idea to set up a timesheet system so the employees can identify what they worked on. Your accounting software should be able to identify and allocate those costs accordingly.
If you are concerned with other employees seeing payroll information that they’re not supposed to, maybe it will be worthwhile to explore a standard charge out rate vs actual payroll details.
Your Turn
In your own organization, do you have visibility into the numbers and are your payroll costs being accounted for correctly? If you’re not sure or have no idea, it’s time to look for a solution that can help you bridge the gap. If you currently don’t have something like this but would be interested in setting something up, make sure to reach out to an accountant who knows the industry.
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At JTL CPA, our goal is to automate your accounting and bookkeeping processes in a way that increases financial visibility. Pair that with our value-added approach and tailored advisory solutions gives you the ability to make sound decisions from good data. Check out our website here: www.jtlaccounting.com.
Thank you for making it to the end of the blog post. If there are topics that you would like to learn more about in the future, please let us know down in the comments.
Until then, see you next time!
#accounting #data #payroll #business #entrepreneurship #success
