Keeping tabs on direct construction costs for a project is pretty straightforward. Take your materials costs, for instance: X number of beams used on the project multiplied by cost of each beam = total cost. Easy! Dealing with indirect construction costs, however, can be another story.
Indirect costs relate to the performance of the job, but they’re hard to track to a specific project. In other words, indirect costs might benefit multiple projects.
Here’s the thing: If you don’t have the full picture of your cost to complete a project, you’ll get a false sense of your profitability. That’s why it’s so important to track and allocate your indirect costs as accurately as possible. Here are a few tips for getting started.
- Identify your indirect costs.
Indirect costs can generally be divided into two buckets: labor and equipment. Some contractors may use only one bucket, while others may use both. Examples of costs that may be included in the indirect labor cost bucket include payroll taxes, workers compensation costs, and employee benefits. Examples of costs that may be included in the indirect equipment cost bucket include fuel, maintenance, insurance, and storage cost related to your owned equipment. The key is to decide what makes sense for your business to accurately determine your project-related costs.
So, we’ve covered labor and equipment, but what about the costs associated with running your business, such as general liability insurance, advertising, and office-related salaries? These costs are categorized as “overhead.” Although typically flat (i.e., they don’t fluctuate) and easier to predict, they’re often the hardest type of costs to allocate. That’s because it’s likely your overhead costs do support projects—just not 100 percent of the time. For this reason, it’s important to consider allocating some of your overhead costs to specific projects.
- Keep separate ledger accounts for each indirect cost bucket.
Once you’ve determined the items included in your indirect costs, it’s time to track them. First, make sure your general ledger has a separate account group for each indirect cost bucket you’ve identified. This is where you will post these costs. Often times a contra account, which is an account with a balance that is opposite of the associated account (e.g., a credit instead of a debit), will be used for each bucket to easily show the total amount allocated to the jobs. From a reporting perspective, this ledger setup will allow you to see a whole bucket of costs and compare the actual amounts incurred to the amount that has been allocated.
- Allocate indirect costs using a systematic and rational method.
Once you have your buckets set, you’re ready to allocate. While there are numerous ways to allocate costs, the method you choose should be systematic and rational. For instance, you could allocate labor costs based on direct labor hours incurred, or on a percentage of total cost per labor hour. Equipment costs could be treated in a similar manner—allocated by total equipment hours incurred.
Most often, contractors will estimate their total annual indirect costs for each bucket and set a predetermined rate to allocate those costs throughout the year. Others will use the actual cost incurred each month and allocate the full amount based on activity during that time period. The decisions surrounding how to allocate indirect costs will vary depending on the nature of your business.
- Let your accounting software share the load.
Many robust accounting systems have built-in functionalities for indirect cost tracking and allocation. This begs the question: Do you know what your accounting software is capable of? If yours has this functionality, you could automatically track and allocate indirect costs with little effort after the initial setup.
- Look forward to better insight into your business.
As I mentioned, keeping up with your indirect costs gives you a clearer picture of your profitability. Another benefit of tracking and allocating indirect costs is the ability to see your actual cost compared to what you expected. This is valuable information to have when bidding and estimating jobs. If you don’t know exactly what your indirect and overhead costs will be, how can you compile an accurate bid?
In order to successfully track and allocate indirect costs, you have to tailor the methods to your business. But don’t worry—we can help you figure out the right buckets and allocation approach, giving you the relevant financial information you need for increased profitability.