If you’re including all of your costs in your job estimates and billing, you are more than likely pricing your jobs correctly, and in turn, maximizing your profits. But are you truly including all of your costs?
The easy part is accounting for all of your “typical” construction project costs and the specific costs for a unique project. You and your team are well aware of those. But indirect costs, which can be significant in the construction industry, are often overlooked in the planning and budgeting process. As a result, so is the true assessment of what the costs, and therefore pricing, should be.
Naturally, not including all costs can have a significant negative impact on profits, among other things. There are a few things you need to be sure to consider for a better understanding of your indirect costs, also called indirect cost burdens. With clear insight into all of the costs associated with a project, you can better estimate, manage, and control these costs, and ultimately see your profits increase.
What are your indirect costs?
Indirect cost burdens are those expenses that are identifiable as costs that can’t easily be assigned to a single construction job. When you compare them to general and administrative costs, these would be the costs that would not be incurred if your company had no contracts. They can be fixed or variable and are not normally generated for a single contract. Typically they include items both on a construction site and back in the office, such as:
- A Project Manager Working on Multiple Projects
- Contract Supervision
- Quality Control and Inspection
- Equipment Depreciation and Amortization
The list goes on. Other items that should be considered as indirect cost burdens are things such as small tools, which can be lost, stolen or abandoned on a job site, and other incidentals that occur on jobs, such as scope creep and rework. These may seem small on their own but taken together they can add up to big losses, which is why it’s critical to be aware of them.
Why do indirect costs matter?
What’s the risk of loss by not allocating, or not correctly allocating, your indirect costs? You may be significantly underpricing your jobs by not considering the cost impact of these “hidden” items. Think about this. If you only capture 70% to 80% of the costs associated with a job, you will not have an accurate picture of the costs, and ultimately could be leaving significant profit on the table. Having an accurate picture of all costs is the key to determining the amount of the maximum profit when the job is complete.
In addition, proper capture and allocation of your indirect costs gives you a clear picture of your business and is critical to your bottom line, for so many reasons, in addition to purely dollars. It’s critical to your:
- Banking, to avoid questions around why your general and administrative costs are high compared to industry averages.
- Budgeting and Estimating, for a clear picture of contract status and profitability.
- Financial Reporting, to properly recognize your revenue.
What can you do to capture and allocate your indirect costs?
A complete solution can’t be found in a single article, but I can give you a start. Different types of contractors require different types of job cost accounting, so there isn’t a “one size fits all” approach, which may make you think this is an overwhelming activity and one to avoid. Not true at all. There are three high level steps that will put you on your way to correctly capturing and allocating your indirect costs:
Step 1: Capture it all. Make a list and ask for input from everyone in your organization. Each individual may provide areas you haven’t thought of, so it may take several rounds to ensure you’ve collected it all. For a true picture of the potential profitability of a job, consider allocating both job-specific indirect costs and non-job-specific administrative and general costs (such as office staff salaries, rent, utilities and marketing).
Step 2: Select the right allocation method. These costs are those that are typically able to be shared among multiple projects. However, since each allocation method has its own pros and cons—and each has its own impact on pricing and tax and financial reporting—this decision is usually best made with help and advice from a construction CPA or accounting professional.
Step 3: Use accounting software to simplify your costing and allocation processes. The good news is that once you get a handle on your indirect costs, there is technology available to automate the process of allocating it between jobs. You can capture costs, calculate a ratio against actual expenses and report these costs in a way that’s accurate and understandable. Software can also calculate and affix indirect costs to a total job cost as each labor dollar is applied and as each piece of equipment is utilized. Seeing this level of detail can improve the accuracy of your billing, gauge future estimates and keep your management informed of a job’s true cost.
The bottom line
If you’re not tracking indirect costs correctly, you won’t get a clear picture of a job’s potential profitability. Without considering the impact of items that may or may not be seen on the job, but are part of what it takes to complete it, your bottom line could be misleading. Including indirect cost burdens in the costs of each and every job, in addition to using the appropriate method to calculate and share them across jobs, can improve your job costing, and give you a better picture of what your contract pricing should really be. Now that’s a burden you should be willing to bear.
Article contributed by Jeff Rubin, MKS&H Senior Auditor
About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.