In the construction industry, understanding and effectively managing overhead allocation is crucial for maintaining profitability and ensuring the smooth execution of projects. Overhead costs are the indirect expenses incurred during a construction project that are not directly tied to a specific task or activity but are necessary for the overall operation of the company. This blog will explore the importance of overhead allocation, key concepts, methods, and best practices to help construction managers and business owners navigate this complex aspect of financial management.
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What Are Overhead Costs in Construction?
In the world of construction, where precise cost estimation is paramount to project success, overhead costs play a significant role. These expenses, often referred to as indirect costs, represent a broad category that keeps your construction business operational but aren't directly tied to a specific project.
Here's a breakdown of the two main cost categories in construction:
1. Direct Costs:
These are expenses that can be easily traced and allocated to a specific construction project. They typically include:
Materials: The cost of raw materials like lumber, concrete, steel, and other supplies used in construction.
Direct Labor: The wages and benefits paid to workers directly involved in building the project, such as carpenters, electricians, plumbers, and laborers.
Subcontractor Costs: The fees paid to specialized subcontractors hired for specific tasks on the project, such as foundation work, roofing, or HVAC installation.
2. Indirect Costs (Overhead Costs):
These are expenses that are essential for running your business but are not directly attributable to a particular project. They are more general in nature and benefit all projects undertaken by your company. Common overhead costs in construction include:
2.1 General & Administrative (G&A) Costs:
These encompass expenses related to running the overall business, such as:
Office rent and utilities
Insurance (general liability, worker's compensation, etc.)
Salaries for administrative staff (accounting, human resources, etc.)
Accounting fees
Marketing and advertising costs
Office supplies and equipment
2.2 Jobsite Overhead Costs:
These involve expenses specific to the construction site, including:
Temporary facilities (portable toilets, trailers)
Permits and licenses
Safety equipment and supplies
Security costs
2.3 Project Management Costs:
These encompass salaries and benefits for project managers, schedulers, and estimators, along with project-related software and communication expenses.
Why Is Overhead Allocation Important?
Effective overhead allocation is essential for several reasons:
Project Profitability Analysis: By allocating overhead costs to individual projects, you gain a clear picture of each project's true profitability. This allows you to identify areas for improvement and make informed decisions about future project pricing and bidding strategies.
Informed Bidding: Precise overhead allocation empowers you to calculate accurate project costs and submit competitive bids. Underestimating overheads can lead to losing bids or encountering financial strain during project execution.
Strategic Resource Allocation: Understanding overhead costs per project helps you optimize resource allocation. You can allocate resources more efficiently based on project needs and ensure your projects are adequately supported without unnecessary overhead burden.
Cost Control and Cost-Saving Opportunities: Overhead allocation sheds light on your overall operational expenses. By identifying areas with high overhead costs, you can implement strategies to streamline operations, negotiate better rates with vendors, and ultimately reduce costs.
Improved Financial Reporting and Decision Making: Accurate overhead allocation contributes to a more transparent financial picture of your construction business. This enables you to generate reliable financial reports for internal analysis and external stakeholders like investors or lenders.
Compliance with Accounting Standards: Generally Accepted Accounting Principles (GAAP) in the US and International Financial Reporting Standards (IFRS) require businesses to allocate overhead costs to projects in a reasonable and consistent manner.
Methods of Overhead Allocation
Several allocated overhead formula methods can be employed to allocate this costs in construction. Choosing the right method depends on the nature of your projects and your business structure.
1. Percentage of Direct Labor Hours
This method allocates overhead costs based on the total direct labor hours spent on a project. The overhead rate per labor hour is calculated by dividing the total estimated overhead costs for a period by the total estimated direct labor hours for that period.
Overhead Rate per Labor Hour = (Total Estimated Overhead Costs) / (Total Estimated Direct Labor Hours) |
If your company estimates $1 million in total overhead costs and 50,000 total direct labor hours for a year, the overhead rate per labor hour would be $20 (1,000,000 / 50,000). For a project requiring 1,000 direct labor hours, the allocated overhead costs would be $20,000 (1,000 x $20).
2. Percentage of Direct Costs Method
If your company estimates $1 million in total overhead costs and 50,000 total direct labor hours for a year, the overhead rate per labor hour would be $20 (1,000,000 / 50,000). For a project requiring 1,000 direct labor hours, the allocated overhead costs would be $20,000 (1,000 x $20).
Overhead Rate (%) = (Total Estimated Overhead Costs) / (Total Estimated Direct Costs) x 100 |
If your company estimates $1 million in total overhead costs and $5 million in total direct costs for a year, the overhead rate would be 20%. This means for a project with $100,000 in direct costs, the allocated overhead cost would be $20,000 (100,000 x 20%).
3. Machine Hour Rate Method (Suitable for equipment-intensive projects)
Suitable for equipment-intensive projects, this method allocates overhead based on the machine hours utilized by each project. It ensures that projects requiring more equipment use absorb a fairer share of overhead, reflecting their actual demands on resources.
Overhead Allocation = (Total Overhead Costs / Total Machine Hours) x Machine Hours for the Project |
Example: If overhead costs are $100,000, total machine hours are 10,000, and a project uses 1,000 hours, the overhead allocation would be (100,000 / 10,000) x 1,000 = $10,000.
4. Activity-Based Costing (ABC)
This method allocates overhead costs based on the activities that drive these costs. Each activity’s cost is then assigned to projects based on their usage.
Example: If activity analysis shows that project management consumes 40% of overhead, and a specific project requires 20% of management time, then it gets 40% of the overhead attributed to project management.
5. Square Footage Method
This method is used primarily in projects where size is a determinant factor, costs are allocated based on the square footage of the project.
Example: If total overhead is $100,000 and the total area under construction is 50,000 square feet, a project covering 5,000 square feet would bear 10% of overhead costs, or $10,000
Factors to Consider When Allocate Overhead Costs
When allocating overhead costs in construction projects, consider the following factors:
Allocation Bases: Choose appropriate allocation bases that reflect the drivers of overhead costs, such as labor hours, machine hours, or square footage.
Cost Pools: Group similar overhead costs into cost pools to simplify the allocation process and enhance accuracy.
Consistency: Maintain consistency in your allocation methods across projects and time periods to ensure comparability and reliability of financial information.
Periodic Review: Regularly review and adjust your allocation methods to align with changing project dynamics and ensure accuracy.
Conclusion
Effective overhead cost allocation is essential for accurate job costing and profitability analysis in construction. By understanding and applying the correct allocation methods, construction managers can ensure financial transparency and control.
Managing overhead allocation requires precision and can be time-consuming. At Construction Cost Accounting, we specialize in providing meticulous bookkeeping services that save you time and ensure accuracy. Let us handle the complexities of overhead allocation, so you can focus on building and growing your construction business. Trust our expertise to keep your finances clear and your projects profitable.
