So far, we have covered a lot of ground learning about construction accounting. We've learned about Job Costing and were introduced to committed costs. Today, we're talking about overhead and overhead allocations. Before we dive into that really exciting conversation, let's do a quick review of the income statement so that when we talk about overhead, we understand how it's affecting this income statement. Because remember, this is what all contractors look at to see how profitable their company is. So far, you should understand revenue. In the world of construction; this is the cumulative amount of Billings on all projects. You should be familiar with cost of goods sold as well. That's a pretty standard piece. In our case, cost of goods sold is equal to job cost. You should be familiar with gross profits too. These are the remaining dollars after all of the job costs have been accounted for.
The next few terms, though, might be fairly new to you. In the construction industry, indirect expenses allow contractors to account for costs that occur because of jobs, but are not attributed to a specific job. These are things like cell phones, equipment depreciation, and an assistant project manager. For instance, an invoice for a cell phone isn't going to be broken down into all of the different projects that it was used on. So, all these types of costs are put into a category called indirect expenses. General and Administrative, or G&A, costs are non job specific costs. These are the costs that are going to occur even if you have no projects tomorrow. You still have to pay the office staff, you still have to pay your accounting firm, and you're still going to have to pay for office supplies. Now, we're going to take indirect expenses, add them to the G&A costs, and put them in a bucket called operating expenses. This is how we account for total overhead. The last line of the income statement is known as net income, or our income from operations. It’s the amount that is left over after all expenses have been accounted for.
While it may seem obvious or irrelevant, knowing these different components of an income statement will help you understand how overhead is calculated. And in order to understand how overhead is calculated, let's dive a little deeper into cost of goods sold. There are direct costs of construction that match job cost reports. And while these numbers, like direct labor of $25,000 and labor burden of $6,000, are important, what really makes the most sense when you look at a financial report are the percentages. Here, we can see that the cost of these projects is about 78% of our revenue, which leaves us with a gross profit of 22%. These are very impressive numbers!
Now, let's look back at the indirect expenses and G&A expenses that make up overhead. These indirect costs of construction should be allocated to a cost of goods sold. You'll sometimes hear that referred to as moving costs above the line. When we talk about moving a cost above the line, we're talking about moving it into a cost of goods sold category, thereby moving it up above the gross profit number. So if we take a look at this, now we can see that total operating expenses are about 19% of revenue. To recoup the cost of overhead, and to pay for all of this, we turn it into a job cost. How do we do that? We spread these expenses across jobs, through what’s called an overhead allocation.
Overhead allocations can get very complicated, and different types of contractors are going to do things a little bit differently based on the way that best suits their business.
First, let's take a look at general contractors. They usually look at overhead as a percentage of revenue. This means they allocate their overhead based on how much their jobs earn. So, if job number one brings in 75% of their revenue, then 75% of the overhead costs are going to be allocated to that job. Meanwhile, the remaining 25% is allocated to the other job that brought in 25% of their work.
Specialty contractors use various methods of overhead allocation. Some will look at overhead as a percentage of revenue like a GC, but specialty contractors can be pretty labor heavy. You might find that they spread their overhead costs based on how much labor was attributed to a given job. Overhead is considered a labor burden, like a payroll tax in this instance. Heavy highway contractors almost always consider overhead as a part of their labor burden.
The mechanics of how this happens can get very detailed, but it's incredibly important that these allocations happen. To understand why, let’s go back to the income statement. Earlier, we saw these cost of goods sold that left us with a 22% gross profit. While this is an amazing margin, it's also incorrect because it's not taking overhead costs into consideration!
Let's see what happens to these numbers after we do an overhead allocation. For this example, let’s use a percentage that a lot of contractors talk about: 15%. If we take 15% off our overhead and move it above the line, we can see that our total cost of goods sold was bumped up because of that allocation. Our margin is now 7.28% rather than 22%. This is a drastic reduction.
Now, one thing that is important to note is that allocation does not affect the bottom line. When we run an income statement after making overhead allocations, we are still going to have the same net income. However, making these allocations gives us a truer sense of the cost of construction.
You might wonder why allocations matter if the bottom line remains the same. But there are three key reasons why contractors do care.
First, let’s begin by talking about how overhead allocation can affect the bidding process. Let’s imagine a contractor uses 15% overhead for an overhead allocation, just because that's what industry experts say is the standard. If the contractor is pricing off their projects with a 15% overhead, based on the income statement we just looked at, that contractor is already in the hole. They are losing money on a project that hasn't even begun. Why? Because we can see that their overhead is actually 19% of revenue after analyzing their income statement. They need to be allocating even more overhead into their bidding process. Here is a second reason overhead allocations matter. Project managers are sometimes compensated based on project performance. If a contractor pays their project manager based on a 22% margin, they have overpaid that project manager significantly. The job costs for the PM’s projects need to take on the responsibility of the overhead they consume before they get paid that bonus. The last reason to care about overhead allocations is simply to make good business decisions. Without overhead allocations, a contractor might look at their income statement and assume that high overhead costs are the reason that net income isn't coming in as expected, because margins are appearing to be 22%. They might start slashing costs when the real issue isn't overhead costs at all. Overhead costs may be in line; the real issue might be that estimators are using incorrect markups in their bids. It's easier to make good business decisions when complete and accurate information is available to you.
Overhead Allocations, along with other accounting workflows, can be difficult to manage in a way that maximizes your organization's efficiencies.
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