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A common method is to allocate indirect costs on the basis of direct labor hours. But this approach isn’t always the best. Consider equipment costs, for example. Contractors who own their equipment often include the costs—such as depreciation, maintenance and repairs—in overhead. But unless all of a contractor’s jobs are equally “equipment-intensive,” allocating equipment costs on the basis of direct labor hours can result in a distorted picture of individual job profitability.
Suppose, for example, that a contractor has two jobs in 2008: Each job has a $1 million contract price and direct costs of $800,000. However, Job 1 is more labor intensive (requiring two-thirds of the contractor’s total direct labor hours), and Job 2 is more equipment- and materials-intensive. The contractor owns its equipment, for which it will incur $150,000 in costs during 2008. It includes these costs in overhead, together with another $150,000 in indirect costs.
If the contractor allocates its $300,000 in indirect costs based on direct labor, then $200,000 will be assigned to Job 1, wiping out that job’s profits. The remaining $100,000 will be assigned to Job 2, resulting in a profit of $100,000. But assume that Job 2 accounts for 80 percent of the contractor’s equipment usage. In that case, it would be more accurate to allocate 80 percent of the equipment costs, or $120,000 to Job 2 and 20 percent, or $30,000, to Job 1. Assuming that the remaining $150,000 in indirect costs are allocated based on direct labor hours, profits on the two jobs are calculated as follows:
Job 1: $1 million
-$800,000 (direct costs)
-30,000 (equipment costs)
-$100,000 (indirect costs)
= $70,000 (profit)
Job 2: $1 million
-$800,000 (direct costs)
-$120,000 (equipment costs)
-$50,000 (indirect costs)
=$30,000 (profit)
As you can see, allocating equipment costs based on actual equipment usage results in a dramatically different financial picture. However, whatever the method of allocating indirect costs, the choice depends on the circumstances and must be reasonable.
Proper accounting for job costs provides many benefits. It tells you the true cost and, therefore, profitability of each job; it enables you to develop more accurate bids, thereby helping you avoid unprofitable jobs; and it gives you the information you need to control your costs more effectively.
Dealing with Change
Change orders are a normal part of the construction business, and change order administration can have a major impact on the way you account for jobs. It is critical to include clear change-order approval terms in your contracts and to implement procedures for obtaining signed change orders on a timely basis.
Without properly authorized change orders, in some cases it may not be possible to recognize additional revenue in the same accounting period in which you incur costs to perform the additional work. This situation can have a negative impact on your financial statements and their evaluation by your banker and surety.
Cash Is Still King
A solid accounting system provides many benefits, but no matter how good or profitable your business looks on paper, it can still fail if you overlook cash flow. You should consider cash flow management when you negotiate contract provisions, such as retainage and payment terms.
You should ensure that everyone in your company understands the importance of cash flow and takes steps to submit paperwork, issue invoices and make collection efforts on a timely basis. Some contractors offer bonuses or other incentives to project managers who manage job cash flow effectively. Effective cash management is essential to maintaining a construction company’s financial health.
Give Your Accounting System a Checkup
It’s important to review your accounting system, procedures and reports regularly to ensure that the system produces timely and accurate information company owners can use to manage the business effectively. A solid accounting system also inspires confidence in the lenders and sureties that underwrite the business and are so vital to its financial health.
Jim Jordan, formerly chief financial officer for a large construction company, is director of construction services for Weaver and Tidwell, LLP. Jordan can be reached at 817.882.7728.
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Accounting & Finance 
