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What Is This Thing Called Overhead?

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What Is This Thing Called Overhead? THE MANAGEMENT SERIES What I s T his Thing C alled O verhead? by GERALD GERMAIN Copyright 2000 Reprinted March 2002 Germain Consulting, Inc. About the Author A well-known member of the advertising agency financial community, Gerald (Gerry) Germain, president of Germain Consulting Inc., has par- ticipated as an innovator in a number of important industry trends, includ- ing the emergence of performance-based compensation arrangements, the design of new employee-compensation methods, and the consolidation of mid-sized agencies in large worldwide- service groups. He has also con- tributed to the overall financial philosophy of the industry, working through both his individual positions and the major associations in the industry. Mr. Germain entered the industry in 1967, after earning a J.D. Degree from New York University Law School. He started as a staff accountant at the agency now known as D’Arcy. After rising through the ranks to senior vice president worldwide treasurer, he moved to Compton Communications, Inc. (now Saatchi & Saatchi Worldwide) in 1978 as its chief financial officer, becoming an executive vice president as well in 1982. In 1984, he became chief financial officer of Doyle, Dane, Bernbach, now DDB. When he left in 1994 to establish his own consult- ing practice, he was vice chairman of the company. His clients include both large and small agencies. Mr. Germain has held a number of key industry-wide positions including chairman of the AAAA Fiscal Control Committee, member of the Board of Directors of the AAAA Workers' Compensation Program, chairman of the Advertising Agency Financial Management Group, and director and treasurer of the Advertising Research Foundation. He has spoken on a number of occasions before industry groups on agency compensation, mergers, and cost-efficiency programs. He moderated a panel at an AAAA Management Conference called “Your Agency: What's It Worth and How Do You Realize Its Value?” Preface AAAA is grateful to Gerald Germain for providing us with “What Is This Thing Called Overhead” for our Management Series of books. Numerous AAAA surveys, and conversations with our member agen- cies, indicate that many advertising executives do not understand the meaning of the term “Overhead” as used in the context of agency/client compensation negotiations. This lack of understanding can be costly to an agency; this book should be help reduce that risk. The views expressed herein are Mr. Germain’s and not necessarily those of the AAAA. Introduction The general definition of overhead, for any business, is “those costs that cannot be directly related to the cost of producing the [business’s] prod- uct.” In advertising, that means non-client-directed expenses. But there are many different views of overhead as related to the advertising indus- try, and even if the very general definition were applied, small changes in the inclusions of the components of formulas can provide major differ- ences in the calculation. Because valid arguments can be made for each definition and calculation, little progress has been achieved in standardizing any approach to this subject. But the result of all these differences has been consistent – most advertisers and their consultants take a jaundiced view of any agency statement regarding its overhead and its rate. Furthermore, the entire subject is beyond the understanding of many in agency management. While they realize that accounting is more of an art than a science, they cannot believe that a concept such as overhead can be capable of so much controversy and distrust. “Just tell me the rate,” they tell their financial managers. And then, without a true understand- ing, they attempt to defend their rates to advertisers who are accustomed to extremely low rates in their own industry due to the direct costing of almost all of their personnel and most of the cost of their plant. It is not surprising, then, that these parties usually only agree on one con- cept, and that is that “Overhead is evil.” But overhead is not always evil and it is most often necessary. Overhead in the agency business that rep- resents otherwise avoidable costly premises, unproductive workers, or otherwise inappropriate spending, is just as wrong as it would be in any other industry. Making that determination, however, is more difficult than citing general or industry-specific cost studies. Overhead, for that matter, is just one element of cost used in determining pricing and we must once again concentrate on the overall value of what we receive, not the components of the price. We have divided this booklet into three sections: • What are the general components of overhead expense? • What are the various methods of treating these components to generate an overhead rate? • What recommendations are suggested for generating greater consis- tency in the overall approach? 1. What are the General Components of Overhead Expense? Every company may establish its own views of the components of over- head, but in the agency business there are some components that are always included and those that are sometimes included, depending upon the agency’s method of handling certain expenses. This section deals with the usual agency expenses and provides commentary on their typi- cal handling. Administrative Administrative expenses include travel, entertainment, and unbillable client costs. These costs may be either directly related to clients (and therefore are appropriately attributed to these clients as “direct expens- es”) or incurred on behalf of the overall business (and therefore are included in overhead). For example: • Travel expenses on a production shoot or client visit that are not billable to the client should be directly allocated to the client. • Meals for a group of employees on an offsite location that is not directly related to a client’s business should be included in overhead. • Unbillable production costs should be allocated to the client to whom the production relates as a direct client cost. It is not uncommon for individuals who are not yet familiar with the advertising industry to assume that all administrative expenses are direct, thereby ignoring the fact that overhead travel and other administrative expenses exist in most other companies. Space and Facilities This category includes rent, maintenance of premises, supplies, sta- tionery, and depreciation and amortization of leasehold expenditures. These are always included in overhead costs. This category also includes expenses that some agencies apportion directly to clients (when possible), e.g., telephone, air and ground freight, and IT charges; the balance of these charges will also be included in overhead. 9 Corporate This category includes agency self-promotion, contributions, business insurance, association memberships, organization dues, subscriptions, and new business expense. With the exception of media subscriptions, which on a rare occasion may be deemed client-directed and allocated as a client cost, all of these expenses are overhead. Without question, new business expenses are considered an agency’s development expenses and should be included in overhead. By defini- tion, these are expenses that are not attributed to any client, since they are incurred on behalf of companies that are not clients. The issue of whether they should be included in overhead rates used to determine charges to clients is sometimes challenged by clients or their consultants, however, and will be discussed in the next section. (In late 2000, the AAAA issued an official “Position Paper” on overhead in which agency contribution to retirement plans and new business costs were addressed.) Professional Fees Professional fees include CPA, legal and administrative fees relating to benefit programs and consulting expense. While some agencies may bill the portion of legal expense relating to copy clearance to clients specifi- cally benefiting from the service, there is little controversy that the remaining expenses in this category are overhead. Payroll-Related Expenses This category includes social security, medical and life insurance bene- fits, disability, retirement provisions for employees, and other statutory requirements based upon payroll. Again, there is no question that all of these expenses are overhead. There are alternate methods, however, by which they may be used in cal- culating an overhead rate. In addition, as in the case of new business expense, some clients or consultants have challenged the inclusion of retirement benefits as an appropriate factor in establishing billing rates for clients. Both of these issues will be discussed in a later section of this booklet. Payroll Payroll is, of course, the most significant agency operating cost (since the larger dollars associated with media purchases and out-of-pocket produc- tion costs incurred on behalf of clients are viewed in the agency business 10 as a pass-through). Payroll is gathered by department, under traditional characterizations including account service, creative, media, research, account planning, production, interactive, accounting, etc. These depart- ments are also grouped as “direct” departments (meaning that the activi- ties of their personnel can be attributed to clients), or “indirect” depart- ments (where attribution cannot or is not done). In addition, direct departments will include indirect expenses, e.g., the administrative time of its personnel, their time away from work, their work on new business, and any other time that is not directly attributable to specific
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