The Hidden Truth About Overhead Allocation That’s Costing Your Construction Business
Most contractors apply a generic 10% overhead and 10% markup on their estimates. This one-size-fits-all approach to overhead allocation drains your construction business of profits you’ve earned.
The right overhead allocation method centers on fairness – distributing indirect costs to projects that caused or benefited from them in a way that reflects each job’s true responsibility. Construction owners and accountants who lack clear overhead allocation understanding struggle to determine project costs. Misallocation creates inaccurate financial statements, skewed profitability assessments, and poor resource management.
Your construction business faces high stakes with overhead cost allocation. Underestimating indirect costs during bidding results in contract losses, while overestimating indirect costs risks bid rejection. Construction companies can choose allocation methods based on direct labor costs, material costs, labor hours, or total direct costs, depending on their specific operations and where most overhead originates.
We’ll show you the hidden truths about overhead allocation that cost your construction business money. You’ll discover different overhead allocation methods, understand which approach works best for your operation, and get practical steps to implement a system that reflects your true project costs.
What is Overhead Allocation and Why It Matters
Overhead allocation distributes indirect costs across multiple construction projects using specific allocation methods. This accounting practice ensures each project bears its fair share of expenses that aren’t directly tied to specific construction activities.
Understanding indirect vs direct costs
Direct costs link explicitly to specific projects – materials, labor, equipment rentals, and subcontractor fees. Indirect costs (overhead) support overall business operations without connecting to any single project. Office rent, administrative salaries, insurance premiums, utilities, and equipment depreciation all fall into this category. You calculate indirect costs by summing all expenses not directly tied to specific projects but necessary for overall business operations.
The role of overhead in construction profitability
Overhead allocation ranks among the most challenging yet essential tasks contractors face. Overhead is one of only two factors that impact your profit margin (the other being markup). Contractors who fail to allocate their indirect costs properly see only a portion of their true job costs. Underestimating indirect costs during bidding results in contract losses, while overestimating may prevent bid approval.
Why misallocation leads to inaccurate job costing
Misallocated overhead creates a disconnect between payroll expenses and job cost accounting, making it difficult to reconcile actual costs with estimated ones. Projects that appear profitable on paper turn out to barely break even or lose money once all costs are accounted for. Failing at accurate job costing means you don’t know which projects, project types, or clients are most profitable – insight vital for smart bidding and strategic business development. Construction companies without proper allocation mechanisms struggle to make informed decisions about pricing, staffing, and expansion.
Types of Overhead Costs in Construction
Your construction business carries different types of overhead costs, and understanding each category helps you allocate indirect expenses accurately. We’ll break down these categories so you can account for all indirect expenses properly.
Fixed overhead costs
Fixed overhead costs stay constant regardless of your business activity level. These expenses continue whether you’re managing multiple projects or experiencing a slow period. Office rent, administrative staff salaries, insurance premiums, property taxes, and depreciation all fall under this category. These predictable costs provide stability in your financial planning but must be covered even during revenue fluctuations.
Variable overhead costs
Variable overhead costs fluctuate based on your company’s activity levels. When your business volume increases, these expenses typically rise in tandem. These include office supplies, equipment maintenance, shipping costs, marketing expenses, and utility bills. Failing to monitor these costs leads to unexpected budget overruns since they don’t remain static from month to month.
Semi-variable overhead costs
Semi-variable overhead combines elements of both fixed and variable costs. These expenses have a stable base component plus a variable portion that changes with usage. Telecommunications have a fixed monthly charge plus variable fees based on usage. Other examples include electricity bills with base charges plus consumption rates, and project managers’ salaries that might include overtime during peak construction periods.
Examples of commonly overlooked costs
Many construction businesses miss these critical overhead expenses when calculating project costs:
- Travel time and transportation – Getting workers, materials, and tools to building sites, especially for distant projects
- Indirect materials – Hard-to-quantify items like nails, staples, glue, and bolts
- Power requirements – Generators, battery replacements, and tool maintenance
- Labor burden – Payroll taxes, workers’ compensation, and other employee-related expenses
Properly identifying and allocating these overhead costs is crucial for accurate project estimates and maintaining healthy profit margins, regardless of which category they fall into.
Overhead Allocation Methods Explained
You’ve identified your overhead costs. Now choosing the right allocation method becomes critical for accurate job costing. Each method delivers different advantages depending on your specific business operations.
Direct labor hours method
This method distributes overhead costs based on labor hours worked on each project. It works well for labor-intensive projects but may not reflect resource usage for projects with varying requirements. You divide total overhead by total labor hours to establish an hourly rate, then multiply by each project’s labor hours.
Direct cost-based method
The percentage method allocates overhead based on the proportion of direct costs incurred by each project. Projects with higher direct costs consume more overhead resources. Easy to implement, but it might not account for differences in project complexity or resource utilization.
Revenue-based allocation
This method assigns overhead costs proportionally based on each project’s revenue. Higher-revenue projects consume more resources and absorb a larger share of overhead. This approach works for businesses with varying project sizes and complexities, ensuring overhead distribution aligns with financial performance.
Activity-based costing (ABC)
ABC allocates overhead based on specific activities that drive costs rather than broad allocation bases. This approach identifies all activities your business performs to complete a job, lists resources used for each activity, chooses standard units of measure, and calculates costs accordingly. ABC provides a detailed view of cost distribution and highlights process inefficiencies.
Machine hours and square footage methods
Equipment-intensive projects benefit from the machine hours method, which allocates overhead based on equipment usage time. The square footage method works when project size determines costs, with allocation based on project area.
When to use multiple methods
Contractors can use multiple allocation methods simultaneously. A coatings contractor might allocate most overhead by labor hours, yet allocate resource consumption overhead based on materials cost. Choose methods that reflect your business operations and where most of your overhead originates.
How to Choose the Right Allocation Strategy
Selecting the right overhead allocation strategy requires careful consideration of your specific business operations. The goal is fairness – distributing indirect costs to projects that either caused or benefited from them in a way that accurately reflects each job’s responsibility.
Aligning with your business model
Your overhead allocation methods should fit your particular situation. Equipment-intensive projects benefit from machine hours allocation, while labor-intensive operations work better with direct labor hours allocation. Contractors can use multiple methods simultaneously for different overhead categories.
Using historical data to set allocation rates
Analyze your previous financial statements to find your allocation percentage. Divide total overhead costs from the previous fiscal year by total direct job costs from the same period. This establishes a rate you can apply to new projects, after adjusting for inflation and business growth.
Working with a construction CPA
A construction CPA develops project-specific allocation strategies tailored to your business operations. We recommend this partnership because it enables more accurate job costing and data-driven decisions that improve profitability across projects. Construction CPAs help you navigate the complexities of allocation methods and ensure compliance with accounting standards.
Avoiding common allocation mistakes
Common pitfalls include:
- Not aligning overhead allocation with bids and budgets
- Inaccurate cost categorization (misclassifying direct vs. indirect costs)
- Choosing inadequate allocation bases that don’t reflect actual resource usage
- Not utilizing accounting software effectively
Conclusion
Proper overhead allocation drives construction business profitability. The common 10% overhead and 10% markup approach fails most contractors. You need a tailored allocation strategy that fairly distributes indirect costs to projects for accurate financial assessment.
Misallocated overhead costs drain profits while creating false project performance pictures. Understanding fixed, variable, and semi-variable overhead costs gives you clarity on true business expenses. This knowledge helps you choose allocation methods that reflect your specific operations.
Which allocation approach fits your construction business model? Direct labor hours work best for labor-intensive projects, while equipment-heavy operations benefit from machine hours allocation. You might need multiple methods for different overhead categories. Distribute costs to projects that caused or benefited from them.
Accurate overhead allocation impacts your ability to bid competitively while maintaining profitability. We recommend working with a construction CPA to develop project-specific strategies for your business situation. When you know your true costs, you make informed decisions about pricing, staffing, and business development that drive sustainable growth.
