Overhead Budgeting and Analysis for Construction Businesses

In the construction industry, managing costs is essential to ensure the success of any project. While direct costs like labor and materials are often at the forefront of budget considerations, overhead costs are equally crucial to ensure profitability. 

 

In this article, we will discuss the intricacies of overhead budgeting and analysis for construction businesses, including the importance of calculating overhead costs, what constitutes these costs, methods for accurate calculation, and strategies to optimize overhead spending.

Why Do You Need To Calculate Overhead Costs?

Construction companies know that staying on budget and on time are critical aspects of a successful project. However, overhead costs often fly under the radar, leading to unexpected financial setbacks. Failing to calculate and account for overhead costs can erode profit margins and jeopardize project viability, especially for projects that operate on slim margins. 

 

So, how can construction companies avoid falling into this trap? Let’s take a look at what exactly makes up overhead costs for construction and how to calculate them.

What Is Included in Overhead Costs in Construction?

Overhead costs include a wide array of expenses that indirectly support the construction process. These include:

 

Administrative Expenses: Office rent, utilities, insurance, salaries, and professional fees.

Advertising Expenses: Billboards, online ads, flyers, mailers, and business cards.

Bonding and Insurance Expenses: Bonding premiums, general permits, and insurance premiums.

Equipment Expenses: Equipment that is not a direct job cost including leased equipment, owned equipment, maintenance, and repairs.

Vehicle Expenses: Leased vehicles, owned vehicles, fuel, maintenance, and repairs.

Labor Burden: Payroll taxes, workers’ compensation insurance, and other labor-related costs.

 

Directly attributable costs such as direct labor, direct material, and direct expenses are not part of overhead costs.

 

Two Ways to Budget Overhead Costs for a Construction Company

Budgeting overhead for a construction company is essential for effective financial management. There are a variety of ways a company can approach this, but here are two common approaches you can consider:

Historical Analysis:

This approach involves examining past financial records and historical data to estimate future overhead costs. Let’s discuss how to use historical data for more accurate cost projections.

 

Analyze the company’s financial statements from previous years to identify trends and patterns in overhead expenses. Break down overhead costs into categories such as utilities, rent, insurance, office supplies, and administrative salaries. Calculate the average annual expenses for each category over the past few years.

 

Adjust these historical figures for inflation, any anticipated changes in the business, or upcoming projects that may impact overhead costs. This approach provides a baseline estimate based on past performance.

Zero-Based Budgeting:

Zero-based budgeting (ZBB) requires a fresh start each budgeting period, where overhead costs are justified from the ground up. Instead of basing the new budget on past expenses, you begin with a clean slate.

 

Identify and list all overhead expenses from scratch. Every expense, no matter how small, must be justified and allocated based on the company’s current needs and objectives.

 

This approach encourages cost-cutting and efficiency improvements as each expense item is rigorously evaluated.

 

While ZBB can be time-consuming, it can help identify unnecessary overhead costs and lead to more efficient resource allocation.

 

Ultimately, the choice of budgeting approach will depend on your construction company’s specific circumstances, goals, and available resources. Some companies may benefit from a combination of these approaches to create a comprehensive and accurate overhead budget. Regularly reviewing and adjusting the budget as circumstances change is also crucial for effective financial management in the construction industry.

Methods for Overhead Allocation in Construction

Allocating overhead costs in a construction company accurately is crucial for determining the true cost of each project and for overall financial management. Here are three common methods for allocating overhead in a construction company:

 

Percentage Method:

This method allocates overhead costs as a percentage of the direct costs or project value associated with each project. Direct costs include expenses directly tied to a specific project, such as labor, materials, subcontractor fees, and equipment costs.

 

To use this method, you calculate a predetermined overhead rate (e.g., 10%) based on historical data and budgeted overhead expenses. Then, for each project, you apply this rate to the total direct costs to allocate a portion of the overhead expenses to that project.

 

For example, if a project has $100,000 in direct costs and the predetermined overhead rate is 10%, the allocated overhead would be $10,000.

 

Labor Hours or Labor Costs:

This approach allocates overhead costs based on the labor hours worked or labor costs incurred on each project. It assumes that overhead costs are directly related to the amount of labor required for each project.

 

Calculate the overhead rate by dividing the total budgeted overhead expenses by the total labor hours or labor costs for all projects. Then, for each project, allocate overhead based on the project’s share of the total labor hours or costs.

 

For example, if a project requires 20% of the total labor hours, and the total overhead costs are $100,000, the allocated overhead for that project would be $20,000.

Square Footage:

This method allocates overhead costs based on the square (or other measurement) footage involved in each project. It is commonly used in construction companies that work on building and renovation projects.

 

Calculate the overhead rate by dividing the total budgeted overhead expenses by the total square footage or square meters for all projects. Then, allocate overhead to each project based on the project’s share of the total space.

 

For example, if your annual project volume is 200,000 SF and project ‘A’  involves 10,000 square feet and the total overhead costs are $100,000, the allocated overhead for that project would be $5,000 (200,000/$100,000 = $0.50 per sf).

 

It’s essential to note that the choice of overhead allocation method should align with your construction company’s specific needs, the nature of your projects, and the availability of data. Some companies may even use a combination of these methods to ensure a more accurate representation of overhead costs. Additionally, regularly reviewing and adjusting your allocation method and rates based on changing volume, project characteristics and overhead expenses is essential for maintaining accuracy in your cost accounting.

How To Reduce Your Overhead Costs

Reducing overhead costs is a goal shared by all businesses. Strategies include:

 

Streamline Administrative Processes: Automate tasks, optimize scheduling, and improve labor management.

Optimize Significant Costs: Renegotiate leases, explore SAAS options, and optimize labor and material costs.

Review Recurring Expenses: Re-quote insurance policies and negotiate recurring costs like printers.

Manage Inventory Levels: Employ just-in-time supply chain management to avoid excess inventory.

Track Reimbursable Expenses: Use apps to track and reclaim costs like mileage.

Common Mistakes When Calculating Overhead Costs in Construction

Calculating overhead costs accurately in construction is crucial for making informed financial decisions. However, there are common mistakes that can lead to inaccurate overhead calculations. Here are some of the most common mistakes to avoid:

 

Misclassification of Expenses: One of the fundamental mistakes is misclassifying expenses as either direct or indirect overhead costs. It’s essential to clearly distinguish between costs that are directly attributable to a specific project (direct costs) and those that support the overall operation of the company (indirect overhead costs). Misclassification can lead to incorrect allocation and distort the true cost of a project.

 

Overlooking Variable Overhead Costs: Some construction companies may focus solely on fixed overhead costs, such as rent and insurance, while overlooking variable overhead costs. Variable overhead costs, like office supplies, utilities, or equipment maintenance, can fluctuate based on the level of activity and should be included in your calculations for accurate project cost estimation.

 

Using Outdated Data: Relying on outdated or inaccurate historical data when calculating overhead costs can result in inaccurate budgeting and cost allocation. Overhead costs can change over time due to factors like inflation, changes in the business environment, or technological advancements. Ensure that you regularly update your data and calculations to reflect current conditions.

 

Neglecting Seasonal Variations: Construction businesses often experience seasonal fluctuations in activity. Failing to account for these variations when allocating overhead costs can lead to underestimating or overestimating expenses for specific projects. Consider the seasonality of your projects and adjust your overhead allocation accordingly.

 

Failure to Consider Project Complexity: Not all construction projects are equal in terms of complexity and resource requirements. Failing to consider project-specific factors, such as the size, scope, location, and duration of a project, can result in inaccurate overhead allocation. Complex projects may require a higher level of overhead support.

 

Not Reviewing and Adjusting Overhead Rates: Overhead rates should be periodically reviewed and adjusted to reflect changes in the business environment, overhead costs, and project types. Failure to update these rates can lead to significant discrepancies between budgeted and actual costs.

 

Incomplete Documentation: Proper documentation of all overhead expenses is essential. Failing to keep detailed records of indirect costs and their allocation can make it difficult to track, verify, and justify overhead expenses.

To mitigate these common mistakes, construction companies should establish clear accounting practices, invest in robust cost tracking and management systems, and regularly review and update their overhead allocation methods and rates. Additionally, seeking the guidance of financial professionals or consultants with expertise in construction accounting can help ensure accurate overhead cost calculations.

How Outsourced Accounting Can Help with Overhead Budgeting and Analysis

Benefitting from Outsourced Expertise

In the world of construction finances, turning to outsourced accounting is a smart move for refining overhead budgeting and analysis. This approach involves partnering with financial experts who specialize in tackling the complexities of overhead cost calculations. By relying on these professionals, construction companies tap into industry-specific knowledge and skills.

Navigating Cost Details with Precision

Outsourced accountants are adept at pinpointing and categorizing both direct and indirect costs, providing a complete financial picture. Using tailored tools and techniques for the construction sector, they use advanced software to accurately track expenses, allocate costs, calculate burden rates, and analyze differences. This approach speeds up calculations while making overhead estimates more accurate.

Unleashing Internal Focus Through Outsourcing

Beyond the numbers, outsourcing frees up internal resources from intricate financial tasks. This lets construction businesses concentrate on their core work, innovation, and skilled project management.

Cultivating Smart Growth and Decision-Making

This streamlined operation not only boosts profitability but also nurtures an environment for strategic growth and well-informed decisions. With outsourced accounting, construction companies set the stage for financial expertise and operational excellence in an ever-changing industry.

Final Thoughts

Overhead budgeting and analysis are integral to successful construction projects. Calculating and managing overhead costs with precision can safeguard profit margins and streamline operations. By understanding the components of overhead, utilizing appropriate calculation methods, and implementing cost-saving strategies, construction businesses can optimize their financial health and project outcomes.

Learn More About Signature Analytics

At Signature Analytics, we support our clients’ day-to-day accounting functions, including:

• Invoicing
• AR management
• Bill processing
• AP management
• Forecasting
• Reporting
• Monthly close
• And more…

Ready to get started with outsourcing your day to day accounting services? Talk to an expert today. 

 

Then, read on to learn Why Your Construction Business Needs an Outsourced CFO.