What Is This Thing Called Overhead?

THE MANAGEMENT SERIES What I s T his Thing C alled O verhead?

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, including 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 consulting 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 agencies, 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 industry, and even if the very general definition were applied, small changes in the inclusions of the components of formulas can provide major differences 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 understanding, 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 concept, 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 consistency in the overall approach? 1. What are the General Components of Overhead Expense?

Every company may establish its own views of the components of overhead, 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 expenses”) 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, stationery, 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 definition, 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 benefits, 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 calculating 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 production 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 departments are also grouped as “direct” departments (meaning that the activi- ties of their personnel can be attributed to clients), or “indirect” departments (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 clients. Usually, the time allocation occurs through an employee time-reporting system. So here’s a point that is sometimes misunderstood–overhead not only includes the cost of the indirect departments, it includes the cost of the indirect time in direct departments. The significance of the latter can be demonstrated by the agency CEO or client who says that the agency’s overhead rate should be 60 percent of salaries, arriving at this conclusion by taking a generalized set of numbers and applying them out of context. Starting with total agency operating expenses as a percentage of gross income, the reasoning is as follows: • If I have a target operating profit of 20 percent of gross income, that leaves 80 percent for operating expenses. • If I am using 50 percent of gross income for salary expenses, that leaves 30 percent (80 percent minus 50 percent) for all other operating expenses. • If I consider all other operating expenses as “overhead,” then my “overhead rate” as a percent of salaries is:

(Overhead) 30% of gross income (Salaries) 50% of gross income = 60% This line of thinking can lead to disaster since it ignores both the indirect time of personnel in “direct” payroll departments and the existence of completely “indirect” departments. Consequently, it is wise to reserve any discussions of this subject with clients or other outside parties until your comfort level with this material has been increased. Otherwise, use an expert in order to ensure that the agency’s position is properly explained (more on this subject in the following section).

In summary, I have now dealt with almost all of the agency expenses. Interest expense has been ignored and is rarely utilized in the agency business as a component of overhead. To summarize, I have provided the checklist that appears on the next page. 11 Agency Expenses Inclusion in Overhead

Direct Expense Overhead Expense Always Sometimes Always Sometimes Travel ✓ ✓ Entertainment ✓ ✓ Unbillable Costs- Client ✓ Non-Client ✓ Rent ✓ Light, Heat, Maint. ✓ Postage ✓ Express ✓ Supplies, Stationery ✓ Depreciation ✓ Telephone ✓ ✓ Info. Systems ✓ Agency Promotion ✓ Donations ✓ Doubtful Accounts ✓ Insurance-Operating ✓ Members., Dues ✓ Subscriptions ✓ New Business ✓ Professional Fees ✓ Payroll Related Exp. ✓ ✓ Payroll: New Business ✓ Account Service ✓ ✓ Creative ✓ ✓ Research ✓ ✓ Media ✓ ✓ Account Planning ✓ ✓ Print Prod. ✓ ✓ Broadcast Prod. ✓ ✓ Public Relations ✓ ✓ Interactive ✓ ✓ Finance/Accounting ✓ ✓ Info. Systems ✓ Human Resources ✓ General Office ✓ Executive ✓ ✓

12 2. What Are the Various Methods of Treating These Components to Generate an Overhead Rate? Remember, the mechanics of calculating an overhead rate are dependent upon the interrelationship of direct and indirect labor, direct costs, payroll related expenses and all other costs. (We are not designing a rate with the primary purpose to bill clients and will discuss the differences between these objectives later in this section.) Since most overhead rates are stat- ed as a function of direct client labor, then we need to (a) collect all of the expenses, (b) subtract those expenses billed or otherwise attributable to clients, and (c) divide the result by client direct labor. The big variable is how we price direct labor.

We can price direct labor under many alternatives (at least nine come to mind), but the most commonly used ones are:

A. Divide the actual salary of an employee by the number of total direct and indirect hours worked.

B. Divide the actual salary plus applied benefits (which are fairly consistent to all employees) by the number of total direct and indirect hours worked.

C. Divide the actual salary by a standard number of direct hours (usually 1,600-1,680).

D. Add all benefits to the previous equation.

E. Use a standard hourly rate for each employee or department, calculate direct labor by applying this rate, and then subtract it in the formula provided in the opening paragraph.

Several questions may be asked: • Which alternatives are the most frequently used? Probably A, C and D. • Why does it matter? Well, it does and it doesn’t. It matters because I will shortly demonstrate how these different calculations result in different rates. It doesn’t matter because the bottom line of the total agency expense, i.e., direct labor plus overhead, should usually be the same. 13 Let me illustrate: Assume we have an agency with $1,100,000 in costs, divided as follows: Direct Salaries $450,000 Related Payroll Benefits 100,000 Indirect Salaries 100,000 Related Payroll Benefits 22,000 Other Client Direct Expense 28,000 Other Expenses 400,000 The only difference in my calculations will then be the treatment of related payroll benefits. See the results below: Alternative Alternative One Two Non-direct expenses: Indirect Salaries $100,000 $100,000 Related Payroll Benefits 22,000 22,000 Other Client Direct Expenses ------Other Expenses 400,000 400,000 Related Payroll Benefits on Direct Salaries 100,000 ---- Total Overhead 622,000 522,000

Direct Labor 450,000 450,000 Related Payroll Benefits ---- 100,000 450,000 550,000

Total Overhead Plus Direct Labor 1,072,000 1,072,000

Overhead Rate 138.2% 94.9%

If representing a lower overhead rate is important to your company, this is one of many ways to do it without changing the total of the costs. Recent trends indicate that many agencies are using a standard number of hours for determining the direct salary rate, plus adding the appropriate benefits to the hourly cost (which spreads the real total cost of the hours to the clients to which it is attributed). They are also charging direct costs to the clients in whose service these costs were generated. These agencies believe that this methodology results in the most effective direct cost allocation, and therefore the most accurate representation of client cost. 14 Inaccuracies exist, however, since the entire process is tied to the degree of care exerted by employees in properly allocating their hours. Keep in mind that no system will ever be perfect and we are merely seeking a rea- sonably accurate portrayal of the cost of servicing clients so that we can have the groundwork upon which to base business decisions.

It is also true that this methodology was originally designed as a source of management information and over the last 20 years has been convert- ed in some cases into a client fee generation system. Since this was not the initial intent, many agencies’financial systems provide room for alternative handling of the data. This has created some degree of distrust regarding the reported data on the part of clients and their advisors. It has been magnified by differences of opinion in the handling of certain expense items previously alluded to in this book. Agencies believe that these items are properly included in billing rates; some clients do not. While there is no question these items belong in overhead, the parties may agree on any reporting system that provides a reasonable pricing policy.

These are the most frequently cited expense items where differing inter- pretations exist:

• New Business Expense: Agencies reason that this is their equivalent of research and development expenditures, since, as a result of the inevitability of client losses, agencies without new business will shrink. They must then apply the fairly unadjustable fixed cost portion of their overhead to a declining base, increasing the overhead rate. Conversely, new business success reduces the fixed overhead cost and assures the maintenance of a stable overhead rate. Clients, however, may hold that they should not have to help fund an agency’s effort to grow.

• Retirement Expense: While pension costs appear to be non-contro- versial, some clients argue that they should not be charged for the expense of an agency’s profit sharing retirement program since these expenses are apportioned from agency profits. Conversely, agencies may argue that the method used for funding retirement provisions should not make any difference, since all companies have a social obligation to provide some form of retirement provisions to its employees, and the profit sharing device may be chosen by agencies so as to maximize flexibility in an unstable environment. Interestingly,

15 clients appear to accept the charges for a 401(k) program. Clearly, if an agency has a consistent record of contributing to the retirement programs of its employees, the cost should be deemed an ongoing expense.

• Deferred Compensation Expense: Agencies argue that this is merely another form of compensation packaged as a device used to maximize employee retention, which benefits both the agency and its clients. Clients debate that this item is often a subterfuge for distribut- ing agency profits.

• Bonus Expense: Agencies argue that a substantial bonus program is now simply an expectation of their employees, and its absence will create a meaningful competitive disadvantage. To clients, this is a yet another hidden profit distribution, and they are concerned that it would raise the agency’s profit above any agreed-upon parameters.

When both parties strongly believe in their respective positions, emotions can run high. While some consensus has been reached in recent years, agreement is not unanimous, and these issues can continue to arise in the future. A simple solution adopted by parties who attempt to avoid this controversy is to agree on a flat or variable fee amount tied directly to the value of the services performed.

16 3. What Can Be Done to Assure Greater Consistency in the Future? If a situation exists where overhead continues to be a determinant of the amount charged for services, then the author has several personal suggestions that are not endorsed by any group or organization (including the AAAA) or even many of his clients. These suggestions are offered for the purpose of initiating a dialogue that may lead to somewhat greater consistency regarding these issues in the future.

1. All overhead rates should be applied to direct payroll and related benefits, as opposed to any other base.

2. There is no reason why agencies can’t utilize the same method of calculating hourly cost. It seems to me that the most uniformly applied method should be the one most frequently endorsed:

Actual salary plus related benefits (including bonus as explained below) divided by a fixed number of hours (1,600 is suggested).

Slight differences, such as the use of a different number of hours in the denominator should make an immaterial difference in the overall calculation.

3. Agencies should include all new business costs, and bonuses to the extent not in excess of three percent of revenue, in all overhead calculations. Retirement benefits would be included in related benefits up to five percent of payroll.

4. Agencies and clients utilize fixed agreed upon overhead rates in fee- based compensation arrangements that require the calculation of actual hourly costs. An even better solution would be to agree upon fixed hourly rates by employee–functional classification, or a fixed fee for the total project provided that an appropriate scope of work has been signed off on by both parties.

5. And finally, everyone recognizes that the definition of overhead as used in this context includes costs that are not directly attributable to clients. Consequently, overhead flows from the nature of our business and does not denote an evil intent.

17 The perfect non-overhead agency would consist of one individual with one client. Except in this situation, he would probably be classified as an employee of the client by the IRS. So for protection, the employee would add another client and a place to work outside either client. And then the employee needs to fill out a timesheet to allocate his or her hours. The employee then also needs to prepare invoices to the clients, thereby requiring some outside assistance. The costs of the space, outside assistance, and the non-client-related time needed for record keeping are overhead. And, so, the cycle begins again…