Construction Today

Pay Attention

Is the devil in the details? It is when it comes to overhead costs, which is why all contractors must know how to calculate, allocate and control them.

By Rick Love

When projecting business performance, most construction company owners recognize there are four main categories to consider: labor, materials, overhead and profit. The components of three of these categories are straightforward, even for those with limited accounting or financial backgrounds. Labor includes wages and related payroll expenses paid to the workers needed to build whatever is being built. Materials are the products and supplies required, and profit is what’s left after the owners pay all the expenses, including overhead.

Where construction owners often make fatal mistakes is with the overhead category. Because many owners do not understand how to recoup overhead costs, they often arbitrarily tack on “X” percent to the estimated material and labor costs. The “X” percent is supposed to cover overhead and profit, yet owners may not really understand the source of the number. They fail to realize the number might not adequately cover all overhead costs, much less provide any profit. And, more importantly, they overlook the fact that overhead costs remain even if there are no construction activities occurring. For these reasons, it is crucial for owners to understand how to calculate, allocate and control overhead costs.

Overhead Categories
When creating and using budgets, owners must recognize the differences in managing labor, materials and overhead. Labor and materials should be managed by percents while overhead normally is managed by dollars. In other words, labor and materials are designated percentages of the company’s revenues, while the general administrative expenses (overhead) are exact costs. In this way, an overhead rate can be computed.

Although the overhead rate varies among construction companies, all have overhead including indirect labor, which consists of office wages for employees who do not work directly on jobs. Additional overhead expenses may include rent, depreciation on owned buildings, advertising, taxes, insurance, legal and accounting fees, utilities and computer costs.

These items are usually fixed in nature. In other words, if the company experiences a business lull, the owner will still have these expenses to cover. Because these expenses are constant, it’s crucial to have a plan to ensure payment for them.

Overwhelmed by Overhead
Construction owners lead busy and demanding lives. Between managing the business and preparing bids, sometimes they just don’t think there’s enough time to worry about things that can and do increase overhead line items. These things include overtime, excess office supplies or needless purchases such as a fancy telephone system or an all-inclusive computer network system. Although these items may seem essential when first considered, owners who are overwhelmed and not focused on the bottom line often do not take the time to consider how much revenue must be generated to pay for them.

Additionally, many owners lack financial knowledge, which also can contribute to being overwhelmed. In part, this can be due to confusing or inaccurate financial statements – sometimes there is too much detail; sometimes there is not enough. In both cases, owners may not know what to focus on or look at in their financial statements.

For example, how does an owner review financial statements and use the information to forecast the next year? What will the company’s material costs be? How much are the wages? How much are the overhead costs? These can be hard to predict.

For example, a company had discrepancies between the income statements and the job estimates. There was one account, which was neither billed directly nor allocated. It was called “bid preparation expense” and was a component of the cost of sales. When asked if they charged their customers for bid preparation, the CEO indicated they didn’t. This item was not accounted for, yet it should have been included as overhead because it was part of the owners’ salaries. The company was losing money by not recovering these services in its job estimates.

Overhead Trends
It’s no surprise that overhead trends are escalating. Labor costs, which are sometimes growing faster than the inflation rate, are one reason. This is partly due to the rising costs of health insurance, worker’s compensation and other employee benefits. Secondly, it is also likely that income taxes will continue to increase along with property and payroll taxes.

Technology is a third driver of increasing overhead costs. Unfortunately, many business owners don’t think about investments in technology as a contributor to their overhead costs, but they certainly are. For example, not only do companies have computers in the office but many have wireless capabilities, too. This enables workers in the field to access the main computer through their laptops. The use of technology can be advantageous for the company, but it also requires a continual monetary output for upgrades and maintenance.

Recouping Overhead Costs
To recover overhead costs, an owner needs top be able to calculate these costs accurately. Many people use an arbitrary number, which may or may not actually cover these costs. Rather than relying on an arbitrary number, use the budget to determine true overhead costs and use them when developing job estimates.

Consider the case where the company has a projection of $1 million for direct labor and $600,000 for overhead for the year. This means that for every dollar spent on direct labor, there is an overhead correlation factor of 60 cents that also must be included in all job estimates. A savvy business owner then adds the profit figure to this cost. If the dollars are managed correctly and the sales figures are achieved, then the overhead costs will be recovered.

However, if sales are lower than expected, all the overhead costs will not be recouped. Then, the owner must either generate more sales or reassess the overhead rate. If sales are higher than expected, the business owner can continue to charge the same overhead rate. When there are no more overhead costs to cover, the excess will be profit for the company and the owner.

Overhead Awareness
Properly construction business performance projections and job estimates make a positive difference in construction company profit earnings. Most contractors feel they estimate labor and material accurately. It is very important to manage these costs effectively, too. What’s often more difficult is calculating accurate overhead costs. Once an owner understand what contributes to and affects overhead, it’s easier to figure out an accurate overhead rate to include in bids and estimates. Additionally, savvy owners don’t neglect the overhead rate once it’s been calculated. Just as labor and materials can fluctuate throughout the year, so can the overhead rate.

Control of overhead costs requires continual attention. It’s important to be vigilant about discovering discrepancies where labor, material and overhead dollars are being spent. It is equally important to determine why the profit is higher or lower than anticipated, which will allow the contractor to manage current projects and to better plan for future construction jobs.

Rick Love is a consulting services director for International Profit Associates and Integrated Business Analysis (IPA-IBA). IPA and its related companies provide comprehensive business consulting, tax planning and business valuation services to companies in the United States and Canada. For more information, call 847-495-6786 or visit www.ipa-iba.com.