The Hidden Costs Killing Your Construction Profits: Overhead Allocation Methods Explained
Overhead allocation methods in construction can silently eat away at your profit margins. Construction work typically brings in margins of 17-19%. You could be charging clients too little if you don’t track your indirect costs properly. This hits your bottom line hard.
Many construction companies find it tough to spread their administrative costs, job site expenses, and project management overhead across projects fairly. What seems profitable on paper might lose you money in real life. The industry’s “10-10 rule” for calculating overhead and profit works for some companies. But overhead costs change a lot between companies of different sizes and project types.
Picking the right allocation approach can give you a clearer picture of your finances and help you make better decisions. Your method should line up with your business operations. You can base it on direct labor costs, material costs, labor hours, or total direct costs. Construction businesses can even use multiple methods at once. This creates custom strategies that let you learn about each project’s real profitability.
This piece will show you what counts as overhead in construction. You’ll see why proper allocation is vital to your profitability and learn the quickest ways to choose methods that fit your business needs.
What are overhead costs in construction?
Overhead costs in construction are the expenses you need to keep your business running that don’t connect directly to specific projects. The average overhead percentage for construction companies runs between 10-11%. This number changes by a lot based on your company’s size and the scope of your projects.
Administrative and office expenses
Your construction business’s operations are built on administrative expenses. These costs include office rent, utilities, insurance premiums, administrative staff salaries, and basic business equipment. Office expenses include everything from rent and furniture to communication systems and supplies. The salaries of your administrative team – bookkeepers, estimators, and office staff – count as indirect costs. Legal fees, marketing, advertising, and professional services also belong in this category.
Jobsite-related indirect costs
Direct costs cover materials and labor for specific projects. Jobsite-related indirect costs help execute projects but can’t be tied to individual jobs. These costs usually cover debris removal, construction waste disposal, and temporary site facilities. The costs of equipment depreciation, repairs, maintenance, and small tools also count as indirect costs. Many contractors make the mistake of labeling these as overhead instead of assigning them to specific projects. This mistake makes general administrative expenses look higher and throws off project profitability analysis.
Project management and software tools
Today’s construction management needs specialized software and project management tools that need big overhead investments. These tools make operations smoother by tracking timelines, managing resources, and connecting budgets with financial oversight. Project management software costs range from $280-$1,200 monthly depending on features and users. Most companies budget $175-$350 per user each month. These systems start as an overhead expense but ended up helping track other indirect costs while providing live expense tracking. Construction-specific accounting software lets you estimate and track overhead better, which helps prevent profit loss through better financial visibility.
Why overhead allocation matters for profitability
Precise overhead allocation is the life-blood of financial stability in construction. In fact, this often-overlooked accounting practice determines if your projects make a profit or quietly drain your resources.
Impact on project bidding and pricing
Your competitiveness in the bidding process depends on accurate overhead allocation. You need to include realistic overhead costs when estimating projects. This will give you confidence that you’re not bidding below your actual expenses. The balance is significant—you’ll lose money on contracts if you underestimate indirect costs during bidding. Your bid might get rejected if you overestimate them.
A proper overhead allocation lets you set the right pricing and stay competitive in your market. It also creates a foundation for accurate revenue recognition on ongoing projects. Your total estimated costs will reflect actual project progress better. Contractors who really understand their overhead structure can develop pricing strategies that keep healthy profit margins and win bids.
Understanding true project costs
You’re basically flying blind about actual project expenses without proper overhead allocation. Jobs need to absorb their fair share of indirect expenses. This is called the overhead rate. The rate shows overhead costs for a period as a factor of total business activity that belongs to a specific job.
Good overhead allocation gives you:
- A clearer picture of your financial position and project profitability
- Better information to discuss change orders with customers
- Real insights for management to see genuine job performance
Avoiding undercharging and margin loss
Construction companies usually operate on tight margins—with average profit margins around 6%. Your business needs margins above 10% to stay stable. The ideal targets range between 15-45% to handle changing expenses.
Undercharging can seriously damage construction businesses. Your pricing must account for all overhead costs. You risk paying more for your services than what clients pay you if you don’t. This negative cycle gets harder to break over time. It can change your entire business model, from your client types to how you build and support products.
Watch and allocate all indirect costs regularly. This will give you the financial clarity to keep projects profitable and your business sustainable.
Top overhead allocation methods for construction
The financial accuracy of your construction projects depends heavily on how you distribute overhead expenses. Here are five proven overhead allocation methods that today’s successful construction companies use.
1. Direct labor hours method
This traditional approach allocates overhead based on your team’s project hours. The formula is straightforward: divide your total estimated overhead by total estimated direct labor hours to get a rate per hour. To cite an instance, if your company estimates $1 million in overhead costs and 50,000 total direct labor hours annually, your overhead rate would be $20 per labor hour. Labor-intensive contractors who want to assign payroll-related overhead to jobs with more labor activity will find this method works best.
2. Direct costs percentage method
The percentage method distributes overhead as a percentage of direct project costs. You can find your overhead percentage rate by dividing total overhead expenses by total direct costs and multiplying by 100. Your company’s overhead percentage would be 20% with $200,000 in annual overhead and $1 million in direct costs. Each project bid should include this percentage to cover all expenses.
3. Machine hours method
We suited this method for equipment-intensive projects that allocate overhead based on machinery usage time. Contractors whose activities depend on equipment of all types will find this approach gives projects using more machine time their fair share of overhead. The formula divides total overhead costs by total machine hours, then multiplies by each project’s machine usage. A project using 1,000 hours would receive $10,000 in allocated overhead from $100,000 in overhead costs and 10,000 total machine hours.
4. Square footage method
Larger building projects benefit from this method that distributes overhead by project size. Bigger projects use more resources and create higher overhead costs. You establish a rate per square foot by dividing total overhead by total square footage across all projects. Each project’s overhead allocation comes from multiplying this rate by its area.
5. Activity-based costing (ABC)
ABC offers more detail by assigning cost codes to specific activities based on consumed resources. This method identifies job completion activities, lists each activity’s resources, assigns measurable units, and then calculates costs. Companies with complex operations can use ABC to calculate materials, equipment deployment, and labor hours for each task. This enables immediate job progress tracking and shows which jobs and activities improve your bottom line.
How to choose the right method for your business
You need to think over your specific operations carefully to find the perfect overhead allocation method for your construction business. The right approach will give a fair distribution of overhead costs across projects that caused or benefited from them. This shows each job’s true responsibility.
Assessing your cost structure
Your overhead expenses have specific drivers that you need to understand first. The size, complexity, duration, and location of your construction projects affect which allocation method works best by a lot. You should look at:
- Your company’s cost proportions (direct vs. indirect)
- Organizational structure (centralized vs. decentralized)
- Project types and typical resource consumption
- Primary business activities (labor-intensive vs. equipment-intensive)
A labor-intensive roofing contractor shouldn’t base liability insurance allocation on truck usage. The same way, using direct labor for allocation might skew profitability when a project has high direct costs but low labor hours.
Using multiple methods for different cost types
The good news is you can use more than one allocation approach. Construction companies can create a custom strategy by using several methods at once. Here’s what you might do:
- Allocate equipment-related overhead based on machine hours
- Distribute labor-related overhead using direct labor costs
- Assign office expenses through total direct costs
This hybrid approach pairs traditional methods with activity-based costing to get better accuracy. Your business changes, so you should review and adjust these allocation methods to keep them working well.
Working with a construction CPA
The complexity of overhead allocation teaches us one thing – “know what you don’t know”. A construction CPA can help you learn about:
- Which costs to allocate (separating fixed costs from variable ones)
- Which method(s) to implement
- What technology to use for tracking and managing allocation
Your CPA helps you decide between the simpler job cost method with a predetermined rate or the detailed general ledger method that tracks actual indirect costs. They also make sure your accounting software supports your chosen allocation strategy – something many construction businesses miss.
The right allocation approach ended up depending on your specific business operations and where most of your overhead comes from. When you implement it properly, you’ll learn more about your finances and make smarter pricing decisions.
Conclusion
Your construction business’s success depends on how well you allocate overhead costs. This piece shows how proper allocation methods affect your bidding success and profits. The average overhead percentage of 10-11% gives you a baseline, but it’s not a rule that fits every construction business.
You might ask which allocation method works best after looking at different approaches. Your specific business operations will determine the answer. Companies with lots of labor do better with direct labor hours allocation. Equipment-focused operations should use machine hours methods. Large projects with substantial square footage might need space-based allocation.
Smart contractors use several allocation methods at once. This combined approach spreads overhead costs precisely across different categories and reveals financial details you couldn’t see before. Setting up these systems takes work upfront, but the clear picture it gives changes how you make decisions and price proposals.
A construction-focused CPA makes this whole process easier. These experts help you spot which overhead costs matter most to your projects. They suggest allocation strategies that match your business model. Their knowledge helps you price projects right – not too high or too low during bidding.
Good allocation methods show you hidden costs that were eating into your profits. This clear financial picture lets you price projects with confidence. You can make smarter business choices and hit those target margins between 15-45% that keep your business growing. Your construction company needs this level of financial clarity.
