Turning Overhead Burden Into a Blessing
If you can accurately predict your profits, you’ll be successful when bidding on projects, avoiding bidding on unprofitable projects, and preventing unwanted surprises. When analyzed, contractors with accurate overhead allocations are more successful in obtaining profitable contracts and controlling those costs overall.
By RICHARD E. GAVIN, CPA, CCIFP
For some things in life, more is better. This especially holds true when it comes to analyzing job overhead costs: the more detail, the better the cost allocation. Allocating overhead costs can be a fairly straightforward process, but the time and effort you put into allocation may directly affect the rewards that you reap.
Accurately allocating overhead costs helps position your company to generate the right level of profits. We have encountered many situations where contractors are unsure how to accurately measure and allocate overhead costs. This can create substantial headaches for your business, leading to unprofitable projects and ultimately, project failure. If you can accurately predict your profits, you’ll be successful when bidding on projects, avoiding bidding on unprofitable projects, and preventing unwanted surprises. When analyzed, contractors with accurate overhead allocations are more successful in obtaining profitable contracts and controlling those costs overall. We recently helped a client in the civil contracting business determine the best methods to allocate his construction overhead, thus helping him improve his bottom-line.
First, we acknowledged that there are a variety of ways to allocate overhead costs. The right allocation for our client will depend on many factors, such as: the labor/material mix of projects, the amount of work that is subcontracted, and the number of activities that are in their indirect cost pool. We had to consider whether their current methods were tracking all of their overhead costs. Their overhead costs specifically included: salaries, equipment repairs, insurance, depreciation, rent, advertising, and shop expenses.
We began with one of the simplest ways to allocate overhead costs. We computed a “burden” rate. This was accomplished by using a direct cost unit (which included labor hours and material costs) as the driving factor. Using this method, we estimated our clients’ total overhead costs, and then allocated these costs for a specific project based on a percentage of direct labor hours or material costs, adding a “burden” factor to the direct labor rate and material costs. For example, on a project that utilized 20,000 labor hours at $25 per hour, the total annual field labor costs were $500,000. With an annual materials cost of $900,000 and annual overhead costs (salaries, shop expenses) at $350,000, we quickly determined the burden rate per labor hour ($350,000/$500,000) was 0.70. Our client then estimated that overhead on their next project, which required 8,000 labor hours (8,000 x $25/hr x 0.70) would equal $140,000. For contractors, such as our client, whose overhead varies heavily according to field labor, calculating overhead based on a burden rate tied to field labor worked well. In addition, we segregated all of the company’s job overhead costs related to their heavy equipment into a separate “cost pool.” We projected an annual number of hours of usage for the equipment and developed a burden rate for the equipment overhead cost pool.
Another method we discussed was the specific tracking method. This method includes tracking specific overhead costs and then allocating the costs to individual projects based on actual usage. Rather than allocating using the same burden rate on every project, this method allocates specific pools of overhead costs to specific projects resulting in more accurate results. For example, our client had a project whose total costs equaled $725,000. When broken down, the labor costs amounted to $195,000 and the project materials costs equaled $355,000. The overhead costs were the remaining $175,000 (or 24 percent of the total project cost). Overhead included: salaries ($140,000 – 19 percent), rent ($13,000 – two percent), equipment repairs ($12,000 – two percent), shop expenses ($6,000 – 0.8 percent), and other expenses ($4,000 – 0.55 percent). For certain projects our client encountered, specifically the projects which varied considerably in size or location, or that utilized different delivery systems, using the percentage-of-cost method to allocate overhead worked well.
With computer-assisted technology, allocating overhead costs are less of a “burden” for our client, thus increasing accuracy and helping them to avoid unprofitable projects. With a higher level of accuracy, our client is better prepared to raise project bids (when warranted). They did hesitate to accept this thought process. They felt that this could potentially result in lost project bids and a loss of work. We explained to them that it would result in lost projects—a loss of unprofitable, cash-draining projects on which they never should have bid. After adopting these methods, the company began to observe a trend. They were bidding on projects where there was a greater chance to be profitable and they were eliminating projects that ultimately delivered a net loss. For some projects, accurately allocating overhead even helped them lower their bids, helping the company close more deals and better manage their risk.
We set up a system with them to periodically compare their actual job overhead costs to the amount allocated to jobs. If we detected large variances, it would force management to reevaluate the allocation calculations, installing a strong system of checks and balances.
As competition gets tougher and customers expect lower bids on contracts, you can ill afford to neglect your actual overhead costs. By adopting an accurate system, contractors can make better informed decisions, reducing risk and maximizing profitability. In this economic climate, you must minimize risk and increase your chances for success.
About the author: Mr. Gavin, CPA, CCIFP is a Partner at Grassi & Co., CPAs where he heads the Construction Practice Group. Grassi & Co., CPAs is headquartered in Jericho and has additional offices in Manhattan, New Jersey, North Carolina, and worldwide through Moore Stephens International Limited. Rick can be reached by calling (516) 336-2440 or via email at rgavin@grassicpas.com.