Everyday operating costs like office rent, insurance, and marketing can have a big impact on your bottom line and cash flow, but they often get out of hand because contractors don’t have the best mechanisms for tracking and controlling them. Since it can be difficult to track and allocate overhead across your construction projects, most contractors end up applying a generic 10% overhead and 10% markup on their estimates.
The problem is, many contractors are unknowingly operating with much higher overhead costs. This especially bites SMB contractors in the construction industry who understandably assume that since their business is smaller it means they are also leaner. The idea is that you have a smaller office, fewer staff, trucks, and computers and you're likely doing a lot of the selling, estimating and administrative tasks yourself, but the truth is that those costs compared to your construction volume are quite a bit higher than the larger competitors in your city doing higher volume. Check out these numbers from CFMA for commercial and industrial contractors. The percentage of overhead in comparison to their COGs is much higher on average the smaller you are.
In this guide, we are going to dive into what costs are classified as overhead in construction, how to accurately calculate and allocate them across project budgets, and some tips for how you can drive your overhead costs down.
Unlike direct expenses tied to specific jobs, overhead represents all of the indirect expenses involved in running your business. From estimating to office supplies and utilities, there’s a long list of applicable costs here. They are typically broken down into three categories: fixed, variable, and semi-variable. Over a long enough period all of these costs can change even though they are in one category.
Fixed – Fixed overhead describes any costs that stay the same over time, no matter your company’s income. A common example here is the rent you pay for your office space each month. Sometimes you’ll hear these described as “dead costs” because they have to be paid even if there’s no revenue coming in.
Variable – On the flip side, variable overhead costs change often, and typically fluctuate with how busy your construction business is. Sales and marketing costs, legal fees, and equipment maintenance are all examples of variable costs you might incur.
Semi-variable – As the name suggests, semi-variable costs are a combination of the two. It includes spending that, though partially independent of your revenue, may have cost elements that rise or fall with your business volume. For example: If you use a truck to deliver materials to a job site, you’re incurring semi-variable overhead costs. The ‘fixed’ expenses here would be your insurance, licenses, and monthly payments, while gas and maintenance would be considered variable expenses. When allocating these, we recommend separating the fixed cost elements from the variable portion.
So how do you make sure you have enough revenue coming in to cover your construction overhead costs? You need a way to allocate your total overhead costs across your projects so you can markup your costs accordingly.
Let’s start with the two most popular methods: project-based and labor-based allocation.
To calculate your overhead allocation using the project-based method, divide your company’s annual overhead cost by your total direct project costs. Then, multiply the result by 100. This determines the overhead percentage that you’ll want to apply to every project bid to ensure all your expenses are covered.
For example, if your company has $200,000 in annual overhead costs and $1,000,000 in direct costs like labor, materials, and equipment, the calculation to determine your overhead percentage rate would look like this:
$200,000 overhead / $1,000,000 direct costs x 100 = 20%
When you’re estimating future jobs, you’ll apply this 20% multiplier to direct costs to cover your overhead.
Another common strategy here is allocating based on labor. This formula adds another variable, and ultimately gives you a dollar amount you can add to your average hourly wage for a job.
To calculate this, you’ll take your overhead expenses and divide them by your direct cost of labor (using numbers either from the previous year, or with whatever you have available).
Let’s say you have $200,000 in overhead costs and $600,000 in direct project labor costs for the previous year. Now, let’s apply the formula to determine your overhead allocation:
$200,000 overhead / $600,000 direct costs x 100 = 33.33% * $39 (example wage rate) = $51.99 per hour
In this example, we’re taking the average fully burdened wage rate and adding 33.33% (or $12.99 per hour) to the labor rate we use in our estimate. This would effectively capture the same overhead cost as the previous example, but just goes about it in a different way.
You might prefer the first method because of its simplicity, or you might want to be able to give your estimating team a higher wage rate to use when estimating. Either way, both of these methods will make sure your overhead is properly accounted for in your estimates.
An extra tip: We see a lot of companies apply their markup only to the direct costs of a job, but we believe that you should markup every expense required to bid, build, and complete a specific project if the contract allows it (not applicable in cost-plus projects).
There are instances where neither the project-based method, nor the labor allocation method will be quite right for your business. In those cases, there are three other ways you can allocate overhead.
Machine hours allocation 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 or floor area is another index sometimes used to allocate overhead costs. 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) 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. To use this method, you’ll define all activities your company performs in the course of completing a job, list the resources required for each activity, and select 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.
Activity-based costing helps contractors understand 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.
Though overhead is unavoidable, there are areas where costs can be actively controlled to reduce your overall overhead rate and increase your profit margin. Here are a few areas where construction companies can often find savings.
Banking Costs - Evaluate your total costs for your ability to transact with your bank and get a few quotes from other banks. Many banks will go through your spend and then give you a proposal on how much they can save you.
Interest Expense - The rates you’re paying for credit lines, credit cards, and financed equipment and trucks can be a hidden expense that erodes profitability and causes variations in your overhead expenses. Negotiate better rates on these items, and use credit in a fiscally responsible way to minimize these expenses. That said, this could also be increasing because your revenue is increasing, so just keep an eye on the number and see if you can improve it.
Insurance Expenses - This includes all types of insurance, from health insurance for employees to business insurance like general liability. These premiums can be overpriced if a business does not take the time to review their options. We suggest you use an insurance broker to compare options and coverages. (👉 Read our full guide to insurance for construction businesses.)
Phone Expenses - Depending on how big your organization is, phone expenses can build up and become complicated for companies to manage well. One simple strategy you can use to minimize the administrative time here is to pay a flat amount to each employee for their usage of their own phone. This also minimizes the costs of buying phones for all those in the organization. One caveat: the downside is that you won’t have access to the number your customers may be calling when an employee leaves the business.
Wages for General and Administrative Employees - If your employees are non-salaried and working overtime in this area it can cause a bloated overhead for your business. You need to evaluate the efficiency of your employees and it might be better to hire more people to minimize these expenses or pay overtime if needed.
🔎 Dive Deeper: Ultimate Guide to Construction Accounting for Emerging Contractors
To build more profit in construction, you have to understand your true overhead costs. And, while it can be a time-consuming process, understanding your overhead and being able to properly allocate those costs across your projects is key to building a more stable and profitable construction business. Plus, when you have a good understanding of your overhead, you can better forecast profitability for the coming months.
CrewCost’s construction accounting software can also help here, as it has specific mechanisms built in to split out your overhead expenses and track how it’s trending over time. Try it free for 30 days (no credit card required💥).