Accounting for Paid Time Off (PTO). Could there be a more boring, mundane, accounting-nerd sort of topic? Probably. But it should matter to you and let me tell you why.
Whether you’re a business owner, banker, consultant or employee, the businesses you are involved in probably have something in common with most other businesses: the cost of labor is either the highest cost of the business or one of the highest costs of the business. Chances are labor costs are being understated in many financial reports by almost 10%. For most businesses, an understatement of labor costs by that much is enough to matter when making decisions based on those financial reports.
Why is this happening in the financial reports you rely on? It is the way PTO is treated. Think about it this way: employees get paid twelve months of the year but they work only eleven months of the year. That month they are paid but not working is very significant and can distort the financial reports.
For manufacturers, distributors or retailers, the Cost of Goods Sold is mostly product costs. But for most of the businesses I look at, labor (including taxes and benefits) is 80 to 90% of total costs. And for most small businesses, Paid Time Off is paid on the “pay-as-you-go” basis. That is, someone takes time off, they are paid while not working, and the cost is expensed at the point the employee takes time off. While simple, this is not the best way to do it. And doing it this way materially distorts most of the financial information produced in small businesses.
For most small businesses, employees get two or three weeks of vacation. Let’s assume two weeks or ten business days. Usually there are at least seven days of paid holidays. And then there is usually about one week of sick leave per year. Add it up: ten days’ vacation, seven days’ holidays and five days of sick leave is 22 days total. And 22 days is the typical number of business days in a month. So employees get paid for twelve months and work for only eleven months. That means that employees are not working 8.3% of the time they are paid. (Some of you are howling, “They’re not working a lot more than that!”)
Does it make sense to expense the labor cost ratably over the year? Or does it make more sense to expense the cost over the period the employee actually works (hopefully) productively in the business? The correct answer is the latter although it is more trouble for the accountants.
So how should it be done? Holidays are usually expensed as they come and go as these aren’t “banked” by employees and aren’t paid upon termination. Vacation and sick leave, if they are banked and payable upon termination should be accrued over the time actually worked and set up as a liability. When the employee takes PTO, their bank is charged (reduced). The effect of this is to raise the effective cost of the actual hours worked.
When does this become a factor? Here’s an example: If you’re estimating time for a contract you probably include the cost of employer taxes and benefits. But do you include the cost of PTO? If not, you’re underestimating the true cost of labor. Another example: You’re costing a product or service for retail sale and labor is part of that cost. If you don’t include PTO, again you’ve underestimated your costs. How about when costing goods that are placed into inventory? Same problem.
What are the symptoms of not treating PTO correctly? Often I hear business owners say they make a good margin on every product or project but at the end of the year they made less money than they expected. Could it be that they have underestimated their labor costs at every opportunity? There’s a good chance of that. Think about it: If PTO is 8% of labor costs and labor costs are 80% of your total costs, you’ve underestimated your total costs by 6.4%. That’s a pretty good bottom line in most businesses.
No comments yet.