Understanding construction overhead allocations
In the construction industry, there are many costs that are not directly allocable to job costs yet are vitally important to consider when estimating job costs, as well as accounting for them.
Many times, construction contractors use the "rule of thumb" of direct costs plus 10-percent overhead and 10-percent profit when bidding on jobs. Often, many job overhead costs, as well as equipment costs, do not get allocated into the job cost when calculating job profitability or the work-in-process schedule.
Determining allocations, methods
The work-in-process schedule needs to have proper allocations of job overhead costs, such as insurance, supervisory wages/fringes, indirect supplies, repair and maintenance, depreciation, small tools, etc., as well as a charge for company-owned equipment used on a job. A company needs to determine a consistent and reasonable method of allocating these types of costs to the jobs. These could be based on labor dollars, labor hours, equipment hours used, total job costs, etc.
The method chosen should be based upon the allocation base that most reflects how an indirect cost is incurred. When including these in job costs, the company also needs to make sure these costs are included in the total estimated costs of the job using the same method. Organizing the general ledger by these cost categories helps in evaluating whether you are over-absorbing or under-absorbing these costs into the actual jobs.
In addition, you probably should be over-absorbing the equipment costs into the jobs because you really should be making money on equipment that is owned by the company. If you are forced to rent this from a third party, you can rest assured there is a profit margin included in the rental rate.
The work-in-process schedule is the lifeblood of a construction contractor. The construction industry is the only industry where costs drive revenue. Key items such as backlog gross profits, estimated cost to complete and backlog sales are critical in evaluating the financial stability and future profitability of the company. Therefore, proper allocation of overhead and equipment costs need to be considered in a company's job cost accounting system to ensure correct reporting of net-gross profit at the job level.
Overhead and equipment allocations are often ignored by the contractor, which results in underestimating of actual costs when bidding a job. There is a potential for an increase in profitability at the job level if all these costs are considered in the estimating process.
The proper accounting and monitoring of the costs are critical for the best-in-class contractors.