Top Considerations for Allocating Indirect Costs

Appropriately managing indirect costs can be complex, yet it is essential in the construction industry, since cost allocation is key to understanding the true cost of any project. Cost allocation, when done appropriately, also provides insight to the profitability of individual projects. However, construction companies and contractors may find it challenging to determine optimum indirect cost allocations confidently and consistently. The following are some considerations and best practices for contractors regarding indirect costs and their allocation methodology, which can improve the financial foundation of their projects.

Recognize How Allocation Affects Job Costing

Your chosen allocation method will impact how you engage in job costing, or project- based accounting, which is important for contractors when projecting the bottom line on a contract for any upcoming project. Direct costs are typically easy to allocate in job costing since they are normally specific, and therefore directly charged to the job. Some types of such costs are direct labor, materials, equipment and subcontractor costs. Indirect costs may include items that are not recognized in bids, or they simply are not contemplated when developing the contract. If that is the case, then looking at the estimating and bidding process is also required. Costing and estimating should always reflect the same methodology in costing, including both direct and indirect costs.

Having a proper allocation method in place for direct and indirect costs helps contractors have a better understanding of their costs of work and makes for more accurate estimates and bids and project contract costs. Remember that consistency is key with cost allocation, so the same methodology used to estimate your job cost should also be used to estimate charge job cost.

Appropriately Classify and Define Indirect Costs

Indirect costs are those that are important to project completion but cannot be directly allocated to one specific project. These include costs identified with more than one project and costs that are not directly related to the project’s onsite construction. Payroll taxes, employee benefits, workers compensation insurance, general liability insurance, and equipment fuel and maintenance are all examples of typical indirect project costs. Consider creating different cost pools to help categorize and later allocate your indirect costs. One common practice is to create separate cost pools for equipment and labor.

Overhead costs has many interpretations, yet no real definition. Most think of it as the office-related costs of operating a business, and it can include both indirect costs and general and administrative (G&A) expenses. However, each have key differences – indirect costs can vary depending on production and volume, but G&A costs are typically fixed and more stable. As a best practice, take time to determine which overhead costs are indirect or G&A, as opposed to generally lumping all overhead costs as indirect, which can increase your overhead rate to an unmanageable level. Remember to use the same methodology for interpreting indirect or G&A costs.

Determine a Systematic and Rational Allocation Method

There are quite a few different methods contractors use to allocate indirect costs. These include direct labor hours/costs, total direct costs, labor hour percentages and various equipment methods/rates. The method you use must be systematic, rational and reflect company operations. To determine an indirect cost rate, contractors may consider either estimating their total indirect costs for the year and establishing a predetermined rate to allocate such costs, or they may calculate actual indirect costs each month in order to allocate an amount based on activity during a certain period of time. This full-absorption method can lead to disproportionate allocations when indirect costs or jobs costs occur unevenly, or with irregular costs oc, such as bonuses or major equipment repairs. Whichever method is chosen, it must be applied consistently.

Understand the Capabilities of Accounting Software

Many accounting software systems now have the capability to track indirect costs and apply an appropriate allocation. Consider an evaluation of your current software to understand its functionality in this area, as well as make certain that it is compatible with your chosen method of allocation.

Use the Data for Better Insights

By tracking your indirect costs, you can have a more accurate look at your project profitability.. Doing so can help contractors more accurately know their real costs of contracts, compile their bids and have more accurate estimations for upcoming projects.

DHG can help you understand your indirect costs and establish an appropriate allocation methodology. For more information, reach out to one of our team members listed below.