How to distribute Overtime Labor cost of Exempt employees – Story of a joint family

A Prelude, but not a Pre-requisite to this blog is
Why reporting OT hours is important – A Lesson I learnt from my mom

Introduction

Joint families? Extended families living under the same roof with an ecosystem in which everyone supports one another. There are differences among members, but the common goal is the success of the whole family. In one such joint family (furniture builders since generations) there lived 4 brothers.  Their parents (Exec Management) live in the same house and are responsible for keeping the family tied together.

 Bro 1 Manages day to day affairs of the house like Finances, making sure all kids are taken care of, buying household supplies, etc. Overhead & Admin
 Bro 2 Goes out and finds people who are in need of furniture in their homes and convinces them to buy furniture from their 4th brother Sales and Proposals
 Bro 3 Builds and maintains the house like building new rooms, or furniture, etc. as the family keeps growing with more kids. Sometimes, he invents new type of furniture, which the Bro 4 can later mass produce and sell. Capital Cost
 Bro 4 Builds and ships the furniture. He also collects cash from his customers after he ensures the customers are happy with the product. Operations / Cost of Goods Sold

All the children (employees) of the house work for typically one of the brothers and are compensated with a fixed weekly allowance (exempt employees!!). There are a few children, though, who work for multiple brothers on a regular basis or a brother is helping another brother by lending one of his children.

The Story

This is a story about a child “John Doe”, who worked directly for his grandparents and was allowed to draw $400 every week from the family funds. He worked 10 hours for each of the brothers every week. In return he collected $100 from each of the brothers making up to his total allowance of $400.

All brothers lived and worked in harmony until the brothers started asking John to work more than his regular 40 hours and John being a loyal family member complied. The confusion was that John being Exempt from OT payout, should not be paid more than $400 every week and John doesn’t care who pays as long as he’s getting paid.

At this point let’s see what happens if John goes about collecting money –

If John goes from Bro1 to Bro 4 in this order, he may end up getting paid $500 for the extra 10 hours worked. To counter that, John can take a signed log from Bro to Bro so that the last Bro can pay him the balance. Doing this, John is deciding how is pay is distributed among brothers. But, only being a worker-bee, does John  understand the implications of his decisions? Let’s see… Say, Bro4 had asked the John to work those extra 10 hours for him and John goes from Bro 1 to 4 collecting his money. Bro4 would pay him only $100, and get production worth $200, unfairly showing his margins higher. On the other hand, if the work was requested by Bro1, John will receive $200 from Bro 1 and eventually nothing from Bro4 again giving Bro4 an unfair advantage. Hence,  John should not be allowed to decide how his cost is distributed across Bros because John is not an accountant. This decision needs to be driven from corporate policy and guided by the grandparents. In order to avoid daily conflict among Bros, it should be embedded in the ERP system’s logic

The Problem

How should such cost be distributed? If we don’t want the employee to decide, then the Corporate policy needs to be embedded in your ERP software’s logic. Now the question is – what logic should be is embedded? The answer is in the answer of  – How does the CFO like to present the Income statement. Let’s have a quick and dirty look at what an Income Statement looks like

 Total Revenue   xx,xxx 
 Bro 4  Cost of Goods  Less x,xxx 
   Gross Margin   xx,xxx 
 Bro 2  Sales Cost  Less x,xxx 
 Bro 1  Administrative Cost  Less x,xxx 
   Net Profit   x,xxx

Hey, but wait… Where’s Bro 3 (the capital cost guy)… His cost is sitting as Capital Assets in the Balance sheet and you get to Expense it based on the capitalization rules being followed.

So, how should the CFO decide to distribute the cost???

The Options

Option 1 (The obvious option)

Irrespective of which Bro had requested those extra 10 hours of work, the cost is distributed evenly across the bros

 Bro 1  Bro 2  Bro 3  Bro 4
 Hours 10 10 10 20
 Cost $80 $80 $80 $160

Although this seems to be the most fair way of distributing cost, there are multiple issues in this solution:

  • Bro 4 received a production worth $200, but incurred cost worth $160 only. In case Bro 4 was running a Cost-to-Cost or Cost+ revenue recognition on his project, he will end up recognising less revenue than he could eventually the organization will lower profit on the Income Statement. On a work based revenue recognition, it will show excess profit on the job, though it will get eliminated on the Corporate revenue.
  • You could be losing cash if your billing method on the project was Cost + margin.
  • By using this method, you are losing an opportunity of moving $20 cost to Balance Sheet in the Capital Asset account by taking Less money from Bro 2. This will also be a hit on the Corporate revenue by $20 for that year. <Think shareholders!!!>

This option suddenly started looking not so logical, eh? But, you may still end up using this option if the CFO wants to live with these issues for ease of understanding of Labor Cost distribution.

Option 2 (The better option)

John always goes to Bro 4 first, then to Bro 3 and then for balance he goes to Bro 1 and Bro 2

 Bro 1  Bro 2  Bro 3  Bro 4
 Hours  10 10 10 20
 Cost (A)  $0 $100 $100 $200
 Cost (B)  $50 $50 $100 $200

With this method, the organization is trying to take care of the limitations posed in option 1. John got his $200 from Bro4, then $100 from Bro 3. For the balance, he could claim $50 each from the other 2 or just from Bro 3.

From an organization standpoint, it doesn’t matter how the $100 is distributed amongst Bro 2 and Bro 1 as both show up as Operations cost in the Income Statement. It is a matter of policy and how the CFO wants to present the numbers to the shareholders.

Let’s see how this option works if the extra work was given by any other Bro.

Bro 3 (Capital Cost) asked for extra work

 Bro 1  Bro 2  Bro 3  Bro 4
 Hours 10 10 20 10
 Cost (A)  $0 $100 $200 $100
 Cost (B)  $50 $50 $200 $100

Bro 2 (Sales and Proposals Cost) asked for extra work

 Bro 1  Bro 2  Bro 3  Bro 4
 Hours  10 20 10 10
 Cost (A)  $100 $100 $100 $100
 Cost (B)  $67 $133 $100 $100

Bro 1 (Administrative Cost) asked for extra work

 Bro 1  Bro 2  Bro 3  Bro 4
 Hours 20 10 10 10
 Cost (A)  $100 $100 $100 $100
 Cost (B)  $133 $67 $100 $100

Yoo! Hoooo!!! The option works perfectly well in all scenarios.

The Conclusion

If you are having a dilemma on how to configure your company’s Labor Cost Distribution for Exempt employees, forward this blog to the client/consultant/Finance organization/ or whoever can’t get his head around the scenario with the following points –

  • It must be mandatory for Exempt employees to report Overtime hours. Yes!!! Even if it has to be tied to their appraisal. Reasons covered in Why reporting OT hours is important – A Lesson I learnt from my mom
  • Employees should not have the choice to distribute their Overtime hours across projects.
  • Organization’s ERP should be smartened up to read the Overtime hours and distribute their cost across projects.
  • The distribution logic is a matter of corporate policy, but Option 2 will provide cleaner Financials.
  • Of Options 2A and 2B, it doesn’t make any difference, and may be a matter policy to whether to apportion Cost of Operations by hours or to try and show Admin costs lower on the Income statement.

Whatever it is, must flow into the Functional Specs of the Extension🙂

In Oracle, this will turn out to be a very complex extension, which very few have had the pleasure of designing the right way… It has to be extension because Oracle has no Out-of-the-box solution yet. Whenever this solution arrives, you’ll see an edit of this section on this blog…

Please feel free to leave a comment below…

Happy learning and sharing


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