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An overhead allocation rate (or burden rate) is sometimes viewed as a mysterious percentage that is applied to a construction company’s job costs, often based on a “same as last year” mindset. For construction company owners and financial executives, it’s crucial to determine what this mysterious rate is based on, or if it is the most appropriate rate to use, because the accumulation of overhead costs impacts job estimates and revenue recognition.  

Most contractors use an overhead rate to allocate indirect costs to individual jobs using a percentage multiplied by either direct labor costs or materials costs, although there are variations, such as direct labor hours or a blending of these. A problem often arises when this rate is not monitored or revisited annually to assess whether it is an accurate representation of the company’s current overhead costs. When this occurs, an over- or under-allocation of costs can occur, thereby skewing financial results and impairing the ability of owners and financial executives to manage the business properly.

Under-allocating indirect costs can result in inaccurate job bids and lead to overages in costs and lost profits, as well as understating revenue when using the percentage-of-completion method. Over-allocating indirect costs can lead to losing bids, as well as overstating revenue when using the percentage-of-completion method.

Following are four steps construction company owners and financial executives should take to ensure the most appropriate job overhead rate is being used from year to year.

1. Review the Indirect Costs That Should Be Allocated to Individual Jobs
Common types of allocable indirect costs include those related to construction facilities such as rent, utilities and depreciation; general construction equipment costs such as rent, depreciation, repairs and gasoline; quality control and inspection; small tools and contract supplies; liability insurance; and indirect labor compensation and payroll taxes (i.e., job supervisor costs).

In addition, any medical insurance, payroll taxes or fringe benefits related to direct labor that are not charged to a specific job should be included as indirect costs and allocated to jobs. Expenses that are not related to a construction activity should not be included as indirect costs (e.g., salaries and benefits of administrative employees who are not directly involved in the construction activity). If an administrative employee was involved in a construction activity for a portion of his or her time, costs associated with that employee for that portion of time should be included in indirect costs.

2. Evaluate the Method of Allocating Overhead
There are two basic ways to evaluate the method of allocating overhead, which are sometimes blended, using either direct labor costs or direct materials costs. Assessing which method is most appropriate for a contractor should be based on the most critical component of the construction activity, labor or materials. For example, if a company’s business is labor-intensive, such as concrete forming, direct labor costs would be a better choice as an allocation method.

3. Double-Check Total Overhead Costs for a Set Period
Go through the process of adding up all the overhead costs for a period end and dividing the sum by the selected allocation base. For example, if total indirect costs for the year ending Dec. 31, 2014, are $2 million and materials costs are $10 million, then the overhead rate is 20 percent ($2,000,000/$10,000,000).

A similar method could be used if based on direct labor if, for example, total direct labor is $8 million for the year ending Dec. 31, 2014, and the overhead rate is 25 percent ($2,000,000/$8,000,000). As a proof of the allocation, the rate, as applied to whichever base selected, should result in the entire overhead amount ($2 million in this example) being allocated to individual jobs, as shown in the chart above.

4. Assess and Adjust to Current Year Budgets
Once an overhead allocation rate has been established based on historical actual results, it then should be assessed and adjusted relative to the current year budgeted amounts. The resulting rate can be used in estimating jobs and the current accounting for jobs. It is imperative to use a systematic and rational method of overhead allocation from year to year to allow for comparability and accuracy. 

In conclusion, ensuring that a construction company uses the most appropriate job overhead rate is an ongoing, fluid process vital to accurate job estimates and bidding, as well as accurate financial reporting. Managers should define indirect costs in the form of written accounting policies and apply the policies consistently. Identification of direct versus indirect job costs can be a confusing and cumbersome process, but it should be easier with written policies in place.

The development of the overhead rate should be based on known criteria and methodologies, and be reassessed periodically to ensure it is still relevant to the company’s core business. The actual rate should be computed annually and then reassessed as compared to the upcoming year’s budget to ensure the accurate estimate of the overhead rate is being employed. Once the routine of defining, identifying, assessing and reassessing are in place, there is no mystery to the overhead rate, and the result is a better managed construction business.  

Donna Caruso is the construction and real estate sector leader for Windham Brannon, PC. For more information, email dcaruso@windhambrannon.com.

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