No. 8: Avoid Wild Pitches with Overhead Allocation

Editors Note: This is the eighth article in the series, “Software Feature Line-Up,” by Mike Ode. Each article focuses on must-have accounting software freatures. To the previous article, click here.

In baseball, successful pitching has more to do with control and accuracy than any other skill. Successful contracting, likewise, is the result of job cost accuracy and control-including those elusive overhead costs.

The key to identifying overhead costs and providing a complete picture of job profitability is the often misunderstood and sometimes complex concept known as overhead allocation.

On the surface, overhead allocation appears simple enough. In addition to direct costs, such as material, labor, subcontractors and equipment costs, contractors must also account for indirect costs-or overhead. Aside from actually knowing what their overhead costs are, the hard part for most contractors involves figuring out a way to classify and distribute these costs.

The good news is that once a distribution method has been chosen, technology can automate the entire overhead allocation process. Contractors can capture overhead costs, calculate a ratio against actual expenses and report these costs in a way that’s accurate and understandable by using a good construction accounting system.

There are generally three steps to successful overhead allocation:

Step 1) Consider All Costs

Most contractors do a good job of tracking their direct costs, and some even break these costs down into cost codes, phases and activities for greater analysis. Unfortunately, the majority of contractors avoid allocating overhead costs altogether. And among those who do, the tendency is to perform only partial allocation-such as labor burden. In either case, contractors will see only a portion of their total financial picture (often a rosy and overstated view).

To get a true account of a company’s financial health, contractors should seriously consider allocating both their job-specific indirect costs (such as project management and estimating salaries, equipment repairs, maintenance, insurance and depreciation) and their non-job-specific administrative and general costs (such as office staff salaries, rent, utilities and marketing).

Step 2) Select the Right Method

Since each overhead allocation method has its pros and cons-and each method will have an impact on contract pricing and tax and financial reporting-this decision is usually best made with help and advice from a construction CPA or accounting professional.

One method, preferred by many contractors because it is simple to use and understand, is known as the “job cost” or “direct cost” method. It uses a single pre-determined rate (or cost driver) multiplied by job costs to determine overhead costs. To establish this pre-determined rate, contractors must estimate the percentage of actual costs that represent overhead (based on historical actual overhead costs).

In some cases, contractors use this method of overhead allocation to establish a flat dollar amount of overhead and add that amount to a specific cost code or type, such as material costs, unit costs and labor hours. Labor-intensive contractors, for example, may choose to apply a flat dollar overhead amount to labor hours, as opposed to material costs, because the labor hours are the single most significant factor that impacts the company’s financials.

General ledger is a second method of overhead allocation and is more complex, but it also allows for more accurate costing. Rather than using an estimated rate, this method requires that contractors track actual overhead costs just as direct job costs are tracked. A percentage of those overhead costs is then allocated to individual jobs based on each job’s percentage of actual costs (or other cost factors such as labor, materials, job revenue or any combination of things). If one project represents 30 percent of the company’s total costs (or other factors previously mentioned), for example, that job would receive 30 percent of the overhead expenses for the period.

By using the general ledger method, contractors can use more complex “weighted” formulas to accommodate overhead costs based on specific characteristics of each job. As a bonus, this method provides management with more specific cost information that can be used to estimate future jobs and control costs on current projects.

Step 3) Use Accounting Software Technology to Simplify Overhead Allocation

With a method of overhead allocation selected and a good job cost accounting system in place, the process of allocating overhead costs is typically automatic and instantaneous.

Contractors using the job-cost method will find that some construction-specific programs have the ability to instantly allocate costs across jobs without any additional data entry. For example, a labor-intensive contractor estimates that $10 per labor hour is the overhead cost formula to be added to actual job costs. Following setup, this calculation is performed each and every time payroll is updated. In turn, the overhead allocation cost, like all job costs, updates the appropriate modules in the system.

Contractors using the general ledger method of overhead allocation in combination with a good job cost accounting system will realize even more benefits. Depending on the size and types of jobs they perform, a flexible job cost accounting system should allocate actual overhead costs by specific costs (labor, material, equipment, subcontract), by all costs, by job revenue, by general ledger account or any combination of these.

No matter which method is used, good accounting software should have the ability to offer both “before” and “after” reports to help a contractor see the effect that overhead has on the bottom line. What’s more, the software should show the results for each job’s profitability as well as for the company as a whole.

Capturing and tracking overhead costs is a job costing challenge that many contractors choose to avoid. But the truth is, these costs are real. To ignore them is to distort the gross profit of jobs and the construction company as a whole. The key to successful overhead allocation comes down to commitment, an appropriate method of distribution and the right job cost accounting system.

Construction Business Owner, September 2009