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Overhead Allocation Methods in Construction Accounting

Yancy Lassiter
Published Aug 22, 2023

Overhead costs are the indirect expenses related to operating a business versus job-specific expenditures. Common types of overhead include office rent, insurance, utilities, administrative payroll, and other costs tied to running a construction company. Overhead may be fixed, variable, or semi-variable. Fixed costs, like rent, are generally constant and independent of project revenue. Conversely, variable overhead is subject to fluctuation as business activities rise or fall. Typical examples include vehicle maintenance costs or spending on sales and marketing. Semi-variable overhead is a combination of both fixed and variable costs.

Regardless of the type of overhead, it’s essential for construction companies to accurately allocate their indirect costs. Effectively assigning a portion of overhead expenses to each job ensures all departments and projects are billed appropriately for their share of the costs, enabling a balanced distribution of resources and ultimately helping to improve accountability. Accurate overhead allocation also allows contractors to identify opportunities for cost savings and other project improvements.

A variety of techniques are generally available for overhead cost allocation. Three commonly-used methods include allocating overhead based on direct labor, machine hours, or square footage. It’s important that contractors choose the methodology most appropriate for their particular business and the types of projects they pursue.

Labor Type Allocation

Overhead allocation associated with direct labor assigns indirect company expenses based on the activity hours or labor costs required by the project. Labor type allocation is based on the assumption that a company’s overhead costs are tied directly to its labor activities.

Machine Hours Allocation

Another method for allocating overhead expenses is based on the machine or equipment time required to complete a project. Overhead allocation based on equipment hours and depreciation costs is most frequently used by construction companies whose activities rely heavily on various machinery or equipment.

Square Footage Allocation

Square footage or floor area is another index sometimes used for overhead allocation. Assigning overhead based on square footage may be especially beneficial on more extensive projects requiring significant amounts of storage space for inventory and supplies.

Activity-Based Costing (ABC)

Activity-based costing (ABC) describes a job costing method companies use to identify the expenses tied to a project. Cost codes are assigned to each activity to facilitate accurate and consistent allocation. The process includes defining all activities a company performs in the course of completing a job, listing the resources required for each activity, and selecting a standard unit of measure for each resource in order to effectively calculate a cost per unit. The cost per unit of each resource item is multiplied by the total units used on a project before totaling all associated indirect costs.

Among its benefits, activity-based costing helps contractors discover which processes are working for them and which ones aren’t. Used for quantifying materials and equipment used, as well as labor hours required to complete each defined task, proper activity-based costing allows for the real-time tracking of job progress. Activity-based costing also enables better control of expenses by identifying overspending trends and allowing contractors the opportunity to take corrective action.

Activity-based costing generally enables companies to make better decisions and maximize their profit by accurately tracking and allocating their expenses to particular job activities. It also provides a better understanding of the actual cost of every project.

Benefits and Limitations of Overhead Allocation Methods

Every overhead allocation method has its own benefits and limitations, making it imperative that contractors choose the approach that best fits their business. For example, the direct labor method of allocation is designed for use if and when there’s a significant correlation between the amount of direct labor and overhead tied to things like office space, utilities, and supervisory expenses.

On the other hand, the machine hours allocation methodology is specific to equipment usage. Depending on the nature of the project, this method of overhead allocation may or not be practical. On many construction jobs, it’s often difficult to associate production with specific machinery or equipment versus tracking the labor required. Square footage allocation or assigning costs tied to the space used for storing materials or equipment can also be challenging due to ever-changing inventory levels.

As with all construction accounting methodologies, the best overhead allocation approach to use depends on an individual company’s cost structures and business objectives.

Role of Technology in Overhead Allocation

Accurate overhead allocation is vital to a construction company’s success and profitability. While it may seem a relatively straightforward process, effective overhead allocation is typically a complex and time-consuming endeavor, requiring contractors to implement the methodology most suited to their particular business model. Despite its potential challenges, though, proper overhead allocation is necessary for success. 

Fortunately for contractors, today’s technology offers solutions for streamlining the process of calculating and allocating a company’s indirect expenses. Purpose-driven construction accounting software like CrewCost is designed with features to automate cost allocation calculations, facilitate customization of allocation rules, and provide contractors with real-time analysis and reporting.

Cost Analysis when using Overhead Allocation and Decision-Making

Real-time reporting and analysis are critical elements of a solid overhead allocation process and provide contractors with actionable cost data that drives improved decision-making. The CrewCost construction accounting platform provides integrated reports and customizable dashboards designed to deliver accurate cost reports, effective variance tracking, and solid cost-benefit analyses.

Contractors who rely on technology for their construction accounting needs understand that generic accounting software simply doesn’t stack up with the construction-specific functionality they find with CrewCost. Designed by experienced building contractors, CrewCost is loaded with trade-specific templates, real-time reporting, and integrated functions and calculations to automate the tracking and allocation of all expenses.

Integration with Financial Management

Among the most substantial benefits of using CrewCost accounting software for allocating overhead expenses is its ability to effectively integrate with other financial management systems. Combined with a company’s other accounting systems and programs, CrewCost enables the seamless flow of data between allocation, budgeting, and financial reporting processes. By connecting the job site with a company’s back office, contractors can take full advantage of CrewCost’s ability to manage every financial aspect of their business.

In addition to automating and simplifying overhead allocation, CrewCost streamlines construction accounting processes like invoicing and billing, tracking time and labor, capturing change orders, and much more. Get on the list for early access and be the first to try CrewCost when it releases in early 2024

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Yancy Lassiter

Yancy Lassiter, a CPA with a degree from the University of Texas, has 12 years under his belt as a Controller and CFO in the construction industry; he’s your go-to guy for finance in the building industry.

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