Conquering Construction Overhead Allocation

Overhead allocation is one of the most challenging concepts that contractors face when running their businesses, but it’s an essential task in determining a company’s profitability.

As detailed by Buildertrend, overhead is, in fact, one of only two factors that impact your profit margin (the other being markup). In other words, to complete a project in the black, construction professionals need to understand their overhead.

On the surface, overhead allocation seems simple. In addition to direct costs for materials, labor, burden, subcontractors, and equipment, companies must account for indirect costs — or overhead.

The difficulty, however, is in the name: indirect costs are all the indirect expenses that aren’t directly related to any project — think rent and insurance — so these costs can get accidentally brushed under the rug when budgets are being determined.

But unlike decades ago, today’s technology, like construction accounting software, gives contractors the ability to easily track overhead costs, calculate a ratio against actual expenses, and report this in a way that’s understandable and accurate.

In this article, we’re going to dive deep into overhead costs: what it is, how to manage them, and how construction solutions simplify the tracking and calculations. By the end, you’ll know exactly how to conquer your overhead in construction.

Article Highlights:

• Accurate overhead allocation is essential for construction financial management, as it impacts profit margins alongside markup and includes indirect costs like office rent and insurance.
• Contractors can use either the Job Cost Method or the General Ledger Method to calculate their overhead rate, helping determine the true cost of projects by factoring in both direct and indirect expenses.
• Construction accounting software streamlines cost control by automating overhead calculations and offering customizable job cost structures to track all expenses, including indirect costs.
• Regular monitoring and allocation of overhead, including all indirect costs and expenses, provides contractors with a more precise understanding of their financial position and project profitability.

Overhead Costs

In the construction industry, overhead costs are the expenses incurred for running the construction business in general. They typically aren’t aligned with any single task nor are they associated with those costs gained throughout a construction project.

Some examples of overhead costs include:

• Office rent
• Taxes for the construction business
• Insurance
• Administrative costs
• Utilities for the office building
• Advertising
• Building permits

Also, note that overhead costs are rarely consistent. The rent may remain stable, but insurance costs, utilities and taxes can all vary depending on the year and the location of the office building.

Tracking Overhead Costs

Many contractors simply fail to allocate their indirect costs, and, of those that do, most perform a partial allocation at best.

In either case, contractors see only a portion of their true job costs.

To get a true account of a construction company’s job costs, contractors must allocate all their indirect costs. Which means construction accountants, or the administrative staff, need to get accustomed to remembering these costs throughout the budgeting process.

The greatest challenge lies in how to calculate the allocation of this type of overhead.

Select Your Overhead Allocation Method

Generally, two methods are used to allocate overhead in construction. Which method to use is a decision best made with the help and advice of a construction CPA, accounting professional or legal counsel.

1. Job Cost Method: This technique uses a single, pre-determined rate multiplied by the direct costs of the job to determine overhead costs.
   1. The rate is typically determined by using historical costs and working with an accountant to come up with the correct percentage.
   2. For example, let’s say a contractor determines they will apply 8% of indirect costs to each project. The contractor will take the direct costs of each project and multiply that by 8% to get a better view into profitability.

2. General Ledger Method: Instead of using an estimated rate, the general ledger method requires contractors to track indirect costs in the same way that direct job costs are tracked.
   1. A percentage of those indirect costs is then allocated to each job based on the job’s percentage of total actual costs.
   2. For example, if one job’s costs represent 25% of the total costs on all jobs, that job receives 25% of the overhead expenses for the period.
   3. The general ledger method also allows for more complex formulas to accommodate “weighting” of overhead costs based on the types of costs that are most relevant to the contractor.

Overall, the job cost method is simpler and, therefore, works better for small companies that not only have fewer projects but also fewer indirect costs.

The general ledger method may be complex, but it better splits the costs among a company’s construction jobs, that way the small projects aren’t overburdened by extra payments.

Either way, experimentation is always helpful. If one method doesn’t work with operational flow, then tweak and move to the next one.

Always keep in mind that these aren’t absolute boundaries. One can create a blended system that works for their administrative needs.

Simplify Your Construction Allocation With Technology

Tracking costs is already difficult, and adding indirect costs will add to the immense calculations.

Depending on the size and type of commercial jobs a contractor performs, a flexible job cost system can be a great tool for any construction company.

A job cost structure can allocate all costs, including actual overhead expenses, by specific costs (labor, equipment, subcontract), by job revenue, or by general ledger account.

One of the many benefits of construction accounting software is that it can help you build your own custom job cost structure — all phases and codes will align with the layout of your company.

A construction accounting solution will offer “indirect costs” as an option in the system and automatically calculate these expenses as they run job cost reports for each project.

As a bonus, the overhead labels can be saved and applied every time as opposed to reentry before each report is run.

Regardless of which method a contractor chooses, accounting software can usually offer both “before” and “after” reports to help a contractor see the effect that overhead has on the bottom line.

The software can also show the results for each job’s profitability as well as for the company as a whole.

Monitoring Your Overhead With FOUNDATION®

The real payoff in performing overhead allocation is the result. Contractors who use and understand overhead costs have a more accurate understanding of all costs.

They’re an important piece in the puzzle that, when put together, shows the real bottom line.

By implementing construction accounting software, like FOUNDATION, to a company’s back-office processes will reduce the strain of indirect cost tracking because the system will do it for you.

FOUNDATION specifically offers job cost tracking, custom budgeting, and cost reporting to ensure that construction overhead allocations are always considered in every budget and report.

Talk to a specialist today to learn more!