For construction company leaders to better understand profit margin, it’s necessary to allocate the costs of each job correctly to help identify trends and efficiencies that may cause jobs to perform better or worse than expected. Understanding these cost components—direct and overhead—is essential for calculating profit margins accurately and making informed business decisions.
Calculation of Profit Margin
Profit is comprised of revenue, including the total contract cost (plus any change orders approved by the customer), less the sum of costs incurred to fulfill that contract. These costs include the following:
Direct Costs
Incurred expenses that are directly allocable to the job, including:
- Materials used, including materials purchased specifically for this job, less any uninstalled materials not used (and available for use on other jobs), plus the cost of any materials on hand.
- Labor costs, including wages incurred that are directly allocable to the job.
- Other specifically identifiable expenses such as subcontractors, site-specific permits, and equipment rented for use in a specific job.
Overhead Costs
Expensed incurred related to jobs worked on during the period but not directly allocable:
- Employee-related costs such as employer taxes and benefits related to field employees, travel to and from job sites, wages for front office employees, and downtime for field employees.
- Insurance, bonds, general business permits and licenses, equipment rentals that are not job-specific, fuel and maintenance costs of vehicles used in the business, equipment repairs for general wear and tear, and depreciation for field equipment and vehicles.
- Rent for the portion of the facility used for materials storage, property taxes, and telephone and utilities expenses.
Generally, these overhead costs do not include general costs of doing business, such as:
- Professional fees related to accounting and legal expenses, advertising and promotion, bad debt, general office supplies and front-office software costs, printing, postage and delivery fees, bank and credit card charges, and income taxes.
- Depreciation for office equipment.
- Rent for the portion of the facility used for front office/administrative activities.
- Employee bonuses and profit sharing/401k contributions not attributable to specific jobs.
Regularly reassessing overhead cost allocation ensures that jobs absorb an appropriate share of expenses. This allocation is known as the overhead rate.
The overhead rate is a sum of the overhead costs incurred for the period as a factor of an input or metric that represents the portion of total activity for the business attributable for a specific job. This may be, for instance, contract value as a percentage of total revenue for the company, or total labor hours spent working on a job as a percentage of total labor hours incurred.
Example of How to Calculate the Overhead Rate
Realistic estimation of overhead costs will aid management in being able to better understand job performance and allow for more accurate information to be available when discussing change orders with customers, and in being able to bid jobs more accurately going forward.
Additionally, better overhead estimates will allow for more accurate revenue recognition for ongoing jobs. The total estimated costs expected to be incurred (which should include an element of the expected overhead burden remaining) will more accurately reflect the total amount of progress that has been made on the job as of period-end and, therefore, how much revenue and profit should be recognized as revenue during the period.
When and How Often Should Overhead Rates Be Reassessed?
As a best practice, overhead rates should be assessed at least annually, or more frequently if changes in costs or circumstances warrant further consideration. These may include, for instance, a material change in insurance premiums or amending the lease agreement for the facility in which the company stores materials and any pre-build job components
To learn more about potential solutions to being able to more accurately track and estimate overhead costs, contact us.
