Managing Overhead: Overhead Allocation Explained
What you don’t know might not kill you, but it can certainly hurt you. In business, nowhere is this more true than in cost management. While you might have an effective job costing process in place for project-related expenses, do you have a good pulse on your overhead? Everyday business expenses like office rent, insurance, and marketing can have a big impact on your bottom line, and should be managed just as carefully as direct job costs. This is where overhead allocation comes in.
In the first part of our series on overhead, we explain the different types of overhead costs and why it’s important to track them accurately. Here, we’ll take a closer look at the two most common methods you can use for overhead allocation, and the role they play in effective cost management.
- Accurate overhead cost allocation ensures your jobs are profitable by including business expenses in your estimates.
- Both project-based and labor-based allocation methods offer simple formulas to help you cover overhead costs.
In This Article
Types of overhead costs
Unlike expenses directly tied to specific jobs, overhead represents all of the indirect, ongoing costs involved in running your business. From estimating, to office supplies and utilities, there’s a long list of applicable costs here – and because overhead can represent a large portion of your company’s overall expenses, it’s helpful to break them down into subtypes.
You’ll remember from part one of our series on overhead that the subtypes are fixed, variable, or semi-variable.
Here’s a quick review of the three:
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 each month. Sometimes you’ll hear this 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 business is. Sales and marketing costs, legal expenses, 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.
The benefits of accurate overhead allocation
Just like how job costing helps you manage labor, materials, and subcontractors, overhead allocation ensures your ongoing business expenses are always included in job estimates. With a realistic view of your total project expenses, it’s easier to:
- Understand your cost structures
- Quickly identify cost drivers
- Optimize your resource allocation
By contrast, inaccurate cost allocation, or neglecting to factor it in altogether, leads to distorted cost data – and potential profit losses.
An overview of overhead allocation methods
The two most popular methods for overhead allocation are quite simple when broken down. One method involves allocating at the project level, while the other focuses on labor. While some folks prefer one method over the other, both will be able to help you cover your overhead costs accurately.
Project based allocation
Project based allocation involves dividing your company’s annual overhead cost by your total direct project costs. Next, you’ll 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.
Labor based allocation
Another common strategy here is allocating based on labor. This formula involves 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 doesn’t fall through the cracks.
An extra tip: We see a lot of companies apply their mark-up only to the direct costs of a job, but we believe that you should mark-up every expense required to bid, build and complete a project if the contract allows it. Keep in mind that in cost plus projects, this isn’t applicable.
Navigating common challenges with overhead allocation
A few common challenges you might run across during the overhead allocation process include:
- Problems identifying appropriate cost drivers
- Managing shared costs
- Splitting semi-variable costs into their respective fixed and variable costs
- Adjusting your allocation methods as needed over time
If you do run into these, don’t throw in the towel just yet. There are a variety of great construction software solutions out there that can help you meet these challenges head on. With construction accounting software CrewCost, for example, you can easily automate overhead allocations, taking the guesswork out of the process. With our easy-to-use platform built by contractors, for contractors you can:
- Accurately track overhead costs
- Generate detailed cost reporting and analysis
- Capture change orders
- Build better job estimates
Instead of relying on outdated, generic accounting software that just doesn’t capture the needs of today’s contractors, be the first to know when we release CrewCost and see how a purpose-built construction accounting software can transform your business today.