I’ll be the first to say it: general accounting is a tough skill to master, and construction accounting is even harder. That’s why it doesn’t surprise me when I see construction business owners come into my office wondering why they’re still not nailing their net profit margin targets even though they’re doing everything “right”. In situations like these, it’s easy to point the finger at overhead, but there’s often more to it.
9 times out of 10 in my experience, out-of-control overhead isn’t the problem - it’s bad accounting. Once you address the underlying issues within your accounting processes, you can focus on improving your gross profits, and then work on untangling any overhead issues.
If you have reached the point where you’re hitting your gross profit goals but still aren’t seeing an acceptable net profit, it’s time to take a look at your overhead costs. To do that, you might need to unlearn some of what you thought you knew about construction overhead and profit.
Key Takeaways
It’s true that overhead expenses make up a big chunk of construction companies’ costs and can easily balloon out of control. More often than not though, you’re not actually spending too much on office supplies. What’s happening here is that your ‘high’ overhead rate is simply masking inaccurate accounting.
Here’s what I mean by this: If you’re wondering why your overhead seems so high, double-check how you’re categorizing your costs. I see a lot of business owners who have cost of goods sold (COGS) transactions hiding down in their operating expenses. This means the problem you’re seeing isn’t your overhead, it’s that your margins aren’t as high as you think they are.
One example of this I see all the time is general contractors running all of their payrolls through their operating expenses and not putting any into their cost of goods sold. For the construction industry and trades, this is bad practice. When you do this, it looks like you have really inflated operating expenses, but the reality is, it’s your COGS that are high - the payroll just isn’t categorized correctly.
How you structure your chart of accounts plays a big role too. Most CoAs are too high-level and don’t provide the level of detail you actually need. For example, you might have an ‘Other Operating Costs’ account with $1 million in it. This is too much money to be sitting in an undefined account. If you want to get a true picture of your overhead, you need to be able to split your accounts in ways that offer more granular details. Then (and only then), can you work on making adjustments.
A lot of contractors charge for overhead on jobs, but here’s my unpopular opinion: It’s pretty much the industry standard to add an overhead markup into your project budget and estimate, but I think it does more harm than good. Before you pick up your pitchfork though, let me explain.
Instead of considering overhead when pricing jobs, you need to focus on target margin. If you hit your target profit margin and keep your overhead costs reasonable, you’ll make a healthy net profit. We’ll talk more about what exactly a good target margin range looks like in a bit, but back to my point: The problem with pricing overhead into specific jobs is that if your overhead is too high, you’ll lose a lot of construction projects you shouldn’t. Plus, if you’re expecting jobs to cover your bloated operating costs, you’ll never be incentivized to actually cut those cuts.
I’m not saying to completely let go of your markup. Instead, try pricing jobs with a markup that doesn’t include overhead. Markup your costs enough to hit your target gross margin, achieve it, and then execute efficiently on the admin side of the business to maintain your net profit. For example, if you have a job that will cost $80k to complete and your target margin is 20%, you need to mark your costs up 25% to achieve a 20% gross profit - no need to further adjust for overhead. Then, keep your overhead at 10-15% of your revenue, and you’ll be at a healthy net profit margin.
Of course, if you want to take more control over your overhead costs, you need to know what should and shouldn’t fall under that umbrella. Unlike direct expenses that are tied to specific projects and earning revenue (material costs, labor costs for onsite workers, etc), overhead represents all the indirect costs that go into running your construction business. This includes things like:
Back to payroll - this is a good time to point out that I see a lot of folks approach it wrong. For example, a lot of business owners put wages in their cost of goods sold, but don’t include payroll tax, health insurance, and other benefits with that. A good rule of thumb is, if employees are COGS employees, then all of these extra expenses should be considered COGS as well.
At the beginning of the article, I mentioned that construction companies should focus on improving their gross profit before worrying about overhead costs. So what’s a good benchmark for companies to target? At a high level, this really depends on the type of work you’re doing. For instance, I wouldn’t expect a roofer and a general contractor to have the same GP goals. Generally speaking though, you should aim for a gross profit margin of 20-50%. Anything under 20% is a red flag you’ll want to address. If you can hit that 20-50% range, you should be looking at a net profit margin of 7-10% (minimum!).
Now let’s talk about how much of your overall revenue should be going to overhead. The CFMA recently released this data on construction overhead for companies to compare with their own benchmarks, but I’ll be entirely honest: the numbers here don’t line up at all with what I see from businesses on a day-to-day basis. This is because way too many businesses aren’t doing accurate accounting.
All this to say, if your numbers line up with this data, great. If not, it’s not something to necessarily stress over. The right overhead percentage for your company is one that leaves you with a healthy amount of net profit. If your net profit is too low, look back to your gross profit first. If it’s healthy, your overhead is too high. If it’s not, your prices are probably too low.
Need a refresher on how to calculate your company’s overhead? Check out this guide to overhead tracking.
So far we’ve covered a lot about how not to approach overhead, now let’s talk about what to do to get a better handle on it.
To me, the best way to control overhead is to pair an appropriately detailed chart of accounts with a clear monthly budget. Aside from that though, there are several ways you can streamline your accounting and reduce your total overhead:
The bottom line is, accurate accounting is everything. The more clarity you can get in your actual construction overhead and profit numbers, the better equipped you’ll be to meet your goal net profit percentage. And when you’ve got that under control, you’re free to grow your business to new heights.
Need help untangling your overhead? Get in touch with Luke and his team at Cruzumi.