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Construction Contractors: Assess Overhead Rates to Prepare for Economic Changes
During times of economic and political instability, it is important for contractors to develop sound budgeting and forecasting practices — especially when managing overhead rates associated with the estimating process.
“With the ‘sequester’ headline news and government budget cuts that may be coming soon, construction contractors should update their systems now to account for these changes and assess how they may affect their workflow,” says Michael Africk, a construction and real estate partner. “Although only some contractors will be directly affected by the budget cuts, they will have a ripple effect across the construction industry,” he adds.
Most construction companies routinely establish an annual budget inclusive of overhead rates at the beginning of the year. However, some rarely revisit it until the following fiscal year, or even later.
“By not regularly reviewing their actual results and re-forecasting budgets, companies could be at risk of over- or under-stating overhead rates, depending on changing economic conditions. This could affect the competitiveness of their bids and bottom-line profitability. If rates are too high, they might lose out on contract awards. If they are too low, they might be in for a surprise at the end of the year,” says Africk.
Labor and overhead
A contractor’s overhead rates are generally made up of labor burden and indirect job overhead.
Direct labor burden incorporates payroll taxes, health insurance or union benefits, workman’s compensation and general liability insurance, and other employee benefits. Indirect job overhead includes other construction-related costs such as supervisory payroll, equipment and maintenance, and a safety program.
Accurate forecasting and routine review of each of these rates is essential to maximize a contractor’s ability to recover costs when business conditions change. While many internal and external dynamics impact rates, some key indicators should be tracked.
Swings in rate calculations
“Typically, we’ve found the biggest swings in rate calculations occur from changes in the organization’s current utilization or expected utilization of labor and equipment. These changes may be the result of increases in efficiency through the use of new hardware and software technology, new equipment, or other business drivers, or there may be a decrease in the overall business activity,” observes Joseph Herman, a construction and real estate partner.
Overhead rates should be monitored on a periodic basis (either quarterly or biannually), so they represent as close to the actual annual results as possible. It is a best practice to consider actual results and each company’s trends when developing new rates, and continue to review volume and spread costs.
For instance, if there is a declining business trend identified since the last measurement date, a consideration to under-allocate rates might be appropriate, so as to not set rates artificially high.
How we can help
Managing your overhead rates is one key to understanding how to improve your profitability. We can help review your overhead rates, identify trends, and update or create a budget.