To maximize profits, avoid "overhead creep".

Construction is a risky business, financially as well as physically. Contractors face notoriously thin margins, volatile revenues, and unpredictable jobsite conditions. For all these reasons, it is critical to keep costs under control.

One of the keys to success in the construction industry is to understand and manage your indirect overhead costs. Inattention to overhead can get you into trouble in two ways. First, without getting a handle on indirect costs and developing a reasonable method of allocating them to projects, it's difficult to measure the profitability of jobs or to prepare accurate bids. Second, unless you continually monitor your overhead costs, they can quickly spiral out of control, wiping out your profits in the process. That's what we affectionately call "overhead creep." Determining the Real Cost of Jobs Construction costs can generally be classified as direct or indirect. Direct costs include direct labor--typically defined as wages and fringe benefits incurred on a particular job--as well as subcontractors' fees, materials, and job-specific equipment or tools.

Indirect costs include items such as corporate office expenses, executive and clerical staff salaries, insurance, taxes, advertising and marketing expenses, professional fees, and office supplies. "Overhead" and "indirect costs" are often used interchangeably, although some use the term overhead to refer only to selling, general, and administrative (SG&A) expenses or some other subcategory of indirect costs.

To get an accurate picture of your costs, it's important to analyze your indirect costs and allocate them to specific jobs whenever possible. Otherwise, at the end-of the year, seemingly profitable jobs may be turned from successes into failures by large amounts of unabsorbed overhead. These costs may be allocated based on the job's related total direct costs, payroll or other comparable measuring stick. By allocating costs to the jobs or activities that drive those costs, you can develop more accurate bids and do a better job of tracking profitability while jobs are in progress rather than after the fact.

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Take equipment, for example. Normally, contractors treat equipment rentals as a direct cost of the jobs they're used on. But contractors who own equipment often lump the costs--which include depreciation and the cost of maintaining an equipment shop--into overhead. By doing so, however, they're essentially flying blind when bidding on jobs. A contractor who doesn't allocate the cost of owned equipment risks underbidding on equipment-intensive jobs and overbidding on jobs with lighter equipment needs. A better approach is to develop allocation rates based on the fair market value of owned equipment and to charge the cost of equipment to jobs by the hour or by the week.

Another example involves the "hidden costs" associated with key personnel on specific jobs, including the project supervisors and estimators who may visit the site, but not be involved at the jobsite on a daily basis. Because these individuals may be used on all jobs, their costs are often overlooked when bidding a specific job.

Other indirect labor costs can also skew your financial picture. These costs include items such as paid vacation, health insurance, and unemployment insurance.

By developing a system to allocate these costs to jobs based on direct labor hours or some other appropriate allocation method, you'll have a better understanding of what jobs cost in "real time."

Including these types of costs in the bidding process should not be viewed as an "extra burden" in the estimate process. Instead, including these costs will result in a more realistic estimate as well as more accurate information about the relative profitability of each of your jobs.

Watch Out for Overhead Creep

In addition to keeping unabsorbed overhead to a minimum, it's also important to be vigilant--during good times and bad--about monitoring and evaluating administrative and other expenses to be sure that they're necessary and reasonable. It's easy for these expenses to creep upward until they're eating up a significant portion of your profits.

Keep a close watch on expenses for staff, insurance, office space and supplies, telephones and utilities, company cars, advertising, subscriptions, travel and entertainment, and so on, and constantly be on the lookout for cost-cutting opportunities. As you evaluate these expenses, be sure to avoid sacrificing long-term financial health for "quick fixes." Cutting advertising expenses, for instance, may immediately boost your profits, but it may hurt the company's bottom line down the road.

Avoiding Surprises

Good cost accounting practices can provide significant benefits to a construction firm. By monitoring overhead costs, keeping them under control, and allocating them to specific jobs whenever possible, you can avoid unpleasant surprises, improve the accuracy of your bids, and spot problems while there's still time to do something about them.

Marc Newman, CPA 

ANCHIN, BLOCK & ANCHIN LLP