Managing Indirect Costs: Best Practices for Your Construction Business
If there is one thing that those in the construction industry understand, it is the value of a stable foundation. For the critical financial decisions that you face as a business owner, think of cost allocation and estimating as the pillar upon which these decisions should be built — if the foundation isn’t solid, then you cannot expect the structure to stand the test of time.
The competitive bid environment leaves little room for error in estimating, especially when winning and losing bids can be separated by a fraction of a percent. As a result, having confidence in your cost allocation and indirect cost rate, which can be a substantial portion of your operating cost, is essential. These key guidelines for efficient, accurate, and systematic indirect cost allocation can help you strengthen your financial foundation.
What is indirect cost?
Construction costs can be classified into three categories:
- Direct costs, including labor, material, and subcontractors
- Indirect costs
- General and administrative (G&A) costs
Indirect costs are broadly defined as costs that contribute to the completion of projects but are not directly allocable to a specific project. Unlike material or subcontractor costs that can be directly charged to a specific project, indirect costs, such as insurance, contract supervision, and quality control, relate to all projects.
Establish indirect cost pools
Both G&A and indirect costs are commonly referred to as overhead; however, there are key differences between the two.
- G&A costs tend to be more stable and remain fixed regardless of volume
- Indirect costs are variable and production-related
Although you need to cover both costs to turn a profit, only indirect costs should be applied as a burden rate to your project estimates and job cost. Your total G&A costs as a percentage of sales should only be used as a reference point for determining your target gross profit percentage for individual projects.
Classify your costs
Run a profit and loss (P&L) report and review the classification of G&A costs and indirect costs. Assess if each cost has both a direct relationship to project volume and is necessary for project completion. If you answer yes for both, classify as indirect.
For example, general liability insurance is necessary for project completion and has a direct relationship to project volume since premiums are based on a percentage of payroll or sales. In contrast, home office rent may indirectly contribute to project completion but is more fixed in nature and has no direct relationship to project revenue and, therefore, should be classified as G&A costs.
For cost pools that include employee salaries such as project management, be sure that all related salary burden, including payroll taxes, insurance, and other benefits are included.
Not all cases are clear-cut. Department salary estimations are an example of costs that can be interpreted as either G&A costs or indirect costs. The key thing to keep in mind is that you should use consistent methodology when estimating and accounting for job costs.
Set up your cost pools
Structure your P&L report so that all indirect cost accounts are grouped separately below direct costs and deducted from revenue to arrive at gross profit. G&A expenses should be listed below gross profit. Depending on the cost structure of your company and management preferences, it may be best to create multiple cost pool categories and rates based on indirect cost type.
For example, management may want to have separate indirect cost pools for project management-related costs and quality control program-related costs. For companies with multiple divisions or business lines, consider setting up division-specific cost pools, as this will help to achieve better matching and more accurate pricing for different types of jobs.
Indirect costs related to company equipment, such as fuel and small tools, should also be included on your P&L report under a separate cost pool. Adjust your direct equipment rates to ensure the indirect equipment costs are allocated appropriately.
If designed appropriately, the P&L report can provide a nice summary for management, showing accumulated indirect cost within each pool, less allocated indirect cost booked to offsetting contra accounts, to arrive at current over or under applied indirect cost. This structure also provides a great tool for identifying inefficiencies and cost-overruns within each cost category.
Select allocation method and calculate rate
There are several different methods commonly used by contractors to allocate cost pools, including labor hour percentages, total direct costs, and direct labor costs. The method chosen must be systematic, rational, based on the unique circumstances of the company, and applied consistently to ensure comparability.
For example, a general contractor with little or no self-performed direct labor should use total direct costs instead of direct labor hours for the allocation, since there is no corresponding direct labor cost base.
Historical cost data or budgeted cost data can be used to calculate rates. Assume, for example, a contractor incurred $1 million in project management-related costs in the most recent fiscal year, and had 100,000 direct labor hours during the same period. Assuming no significant rate changes are expected, the resulting rate would be $10 per direct labor hour.
Apply indirect cost within accounting software
It is important to understand the options within your accounting software package before selecting an allocation method. Most software packages designed for contractors have the capability to apply indirect cost automatically based on calculated rates. Check to make sure there are options within your software’s settings to apply indirect costs using the specific method you choose (i.e., weekly with payroll based on labor hours or direct labor cost, or monthly based on a percentage of total direct costs). If possible, within your chart of accounts set up separate contra accounts and link them to the appropriate indirect rates in the system. Be sure to enter the same rates in your estimating software if a separate package is used.
Establish a policy for rate adjustments
Given how quickly things can change in the construction industry, your rates should be evaluated at least quarterly for accuracy. If you notice significant accumulation of over or under applied cost pools on your P&L report, further analysis should be conducted to understand the underlying reason and determine if adjustments to rates are needed.
For some contractors, there may be seasonal variations in the timing of work that can lead to temporary over or under applied cost accumulation. Similarly, timing related to bulk purchases of non-inventoried supplies and payout of project manager bonuses can generate temporary fluctuations. In these cases, rate adjustments may be unnecessary.
Your annual or quarterly budget can be a helpful tool in evaluating the need for rate adjustments. As you plan for the upcoming period, compare your historical rates to your forecast and adjust accordingly. As a final step, a formal roll out with clearly documented details of your company’s policy for overhead cost allocation will help encourage consistency and understanding.
There are already plenty of inherent risks in the construction industry, so it is important to capitalize on opportunities to control that risk, particularly as it relates to financial loss. Make no mistake, the time and effort you invest in improving systems for allocating and tracking overhead costs will pay off with enhanced bottom line profitability, improved financial reporting, and more confidence in critical bid/no-bid decisions.