Overhead costs are a broad category of costs that are not applicable to one construction project. Instead, they are spread over all projects. Generally, there are two types of overhead costs: indirect costs and general and administrative costs (G&A).

Types of Costs

Indirect costs are expenses related to job activity while indirect costs are tied to multiple jobs. These costs are hard to allocate to just one project. Direct costs, on the other hand, are clearly associated with one project. For example, materials are generally for a certain job, so it’s considered a direct cost. Equipment can be used on every job and is therefore an indirect cost. Even so, certain types of equipment might be used more on one job than another. In this case, a percentage of its cost would be allocated to specific projects.

G&A costs are associated with running the business. They are not related to the construction or sale of goods or services. All projects benefit from G&A costs. As with indirect costs, some projects use more G&A resources than others. G&A costs include office rent, administrative salaries, advertising, marketing and promotional expenses, general liability insurance, office supplies, accounting and legal fees, subscription fees, utilities and more.

Exact information on overhead costs need to be included in job costs and estimates to accurately reflect the true cost of a project. Contractors that ignore these costs or fail to allocate them to each job risk losing money.

Job Costing

Job costing is defined as allocating all direct and indirect expenses and revenues to each respective job. Most contractors have numerous jobs going on at the same time. This may make it difficult to match exact overhead expenses to their respective revenue source. The number of transactions that occur during any given project make job costing even more important to being profitable.

Job costing provides detailed information regarding the profitability of a given contract. A contractor’s accounting staff is charged with reporting the income and expenses associated with each construction project. This ensures that the final price covers all overhead expenses.

Allocating Overhead

A certified public accountant who specializes in construction accounting should be consulted on the best way to allocate overhead costs. There are several questions to consider including:

• What are the real costs associated with completing the job?
• What costs are overhead costs?
• What is the best method for allocating overhead?
• What technology is appropriate for the company?

For example, there are the costs associated with running and maintaining equipment which must be taken into consideration. Some contractors allocate the exact costs of running the equipment on the job. Other contractors might allocate a percentage of the estimated costs of running the equipment based on the time needed on each project. They might use an hourly or day rate for each piece of equipment.

Distributing Overhead Costs

There are several methods for allocating overhead. These include total direct job costs, direct labor costs, direct labor hours, equipment costs and more. The right method depends on the company and the type of work it does. An HVAC contractor may have higher labor costs than a roofing contractor. In this case, it would make more sense for the HVAC contractor to allocate overhead based on direct labor hours. In other circumstance this might not make any sense. If labor is not intensive on a project, it might be better to use total direct job costs to allocate overhead.

Determining an Overhead Rate

There are a couple of ways to determine overhead rate. Contractors can estimate overhead costs for each job using an established rate based on a percentage of revenue or percentage of direct labor costs. Contractors can also track actual costs in their general ledger (G/L) and distribute them proportionally across all jobs. Contractors can then fine tune the allocation of these costs by using a set portion from each G/L account or a certain portion to certain accounts. This method is called the proportion of direct costs. It is considered more accurate than the rate of costs or revenue method. It is also more difficult to determine the correct percentage to use.

With the rate of costs or revenues method, a contractor is looking at one job at a time with some level of certainty about the relationship between how much a job costs or brings in and the overhead it incurs. With the portion between jobs method, a contractor looks at the job’s share of the associated overhead costs.

Historical data can be used to determine the overhead percentage. For example, if the overhead rate was approximately 10% of job costs last year, this percentage can be used this year if it is adjusted for inflation. The contractor can then use this rate for all job cost estimates. By comparing historical costs over time, a contractor can reasonably predict the amount of overhead costs that must be recovered to remain profitable.

Contractors can also look at benchmarks to determine their overhead costs compared to similar companies in the same sector and geographic region. This will help contractors to determine if overhead costs are in alignment with the competition. If overhead costs are much more than other companies, an analysis should be done to determine why.

Technology

There are all types of construction accounting software on the market to help accounting professionals. Depending on company size, Excel spreadsheets may be enough to track and allocate overhead costs. Most contractors will need a more sophisticated program. Make sure to choose one designed to allocate overhead to distinct jobs, so it doesn’t have to be done manually. Discuss options with a construction accountant for help choosing the right system for the business.

Understanding the relationship between overhead costs and job profitability is very important. Overestimating overhead costs on a job can make a contractor less competitive while underestimating overhead costs will make a contractor less profitable. Contractors should keep overhead cost allocations up to date.

Prices are always increasing, innovative products, services and technologies are improving productivity, and numerous other factors are impacting overhead costs. It is a good practice to look at overhead costs at least on an annual basis.