Construction Overhead Costs: Explained
For construction companies and contractors, understanding the concept of overhead costs is crucial to your business's success.
Simply put, Overhead (cost) in construction is the cost of running the business.
It can include the cost of executing projects, the expenses required for normal day-to-day business operations, and everything in-between.
Getting a complete grip on overhead costs is notoriously difficult for most small and new companies and contractors.
But this guide will explain pretty much everything you need to know about overhead costs.
We'll discuss the types of overhead costs and how to calculate them.
And finally, we provide some valuable tips on how you can control your overhead costs.
What are Overhead Costs for Construction Projects?
Running a construction business isn't easy, especially executing building and renovation projects. They require tremendous attention to detail and demand the strictest of accountability practices for project planning and budgeting purposes.
It is not uncommon for a construction company to lose track of the exact amount used to complete a specific project. In addition, it can be a daunting task to pinpoint and record every expense accrued while working on multiple projects.
Preparing an estimate for any construction job involves making overhead cost projections. These projections should aim to be as accurate and inclusive as possible so that a comprehensive bid can be submitted at the beginning and a profit guaranteed in the end.
Construction materials, tools, equipment rental, labor costs, mobilization costs, travel expenses, insurance, sub-contractor fees, and salaries, to mention a few, are all examples of overhead costs for construction projects.
These are a lot of things to keep track of and account for. So it is no surprise that some major and minor expenses are usually left out of the equation to the company's detriment.
Thankfully, however, all these business expenses can be categorized under two broad types, which can help you to classify better and calculate them:
- Direct overhead costs
- Indirect overhead costs
Let's look at both of these in a little more detail.
Direct Overhead Costs
These are the expenses that can be directly connected to a specific construction project.
Direct or job overhead costs are unique to a particular project, and they change with each one. These types of costs are much easier to document and calculate than the other type of construction overhead costs.
With direct overhead costs, you will find the expenses that are required to complete a project, such as:
- Cost of building supplies — materials, and equipment - raw materials, heavy-machinery rental (loaders, excavators, jackhammers), etc.
- Project-specific salaries — cover the labor cost for a particular project, including salaries for subcontractors, laborers, and tradespeople.
- Temporary office spaces — which cover the cost of trailers, and leased office spaces.
Numerous other construction expenses can be classified under direct overhead costs, such as mobilization costs, travel expenses, temporary utilities (hydrants, electricity generators, sanitation facilities), permits, fines incurred during the project, and other related costs.
Indirect Overhead Costs
Understanding indirect overhead costs should be pretty straightforward. These expenses cannot be allocated to just one construction project.
The cost of doing business is filed under indirect overhead costs. And because this involves work done spanning many months and involving multiple projects, it is usually calculated annually.
The office expenses during this period are then shared proportionately across these projects, depending on their size.
Under indirect overhead costs, you can find expenses such as:
- Office space and expense — which covers the cost of rent, utilities, furniture, phones, office supplies, internet, and vehicles.
- Salaries and benefits of the office staff — which cover the wages and benefits paid to executives, administrative employees, accounting team, bookkeepers, etc. As opposed to those who are employed just for one specific construction project.
- Professional certifications & affiliations — if you belong to a specific Guild or Chamber of Commerce or Professional Association, etc.
- Miscellaneous expenses — payments made for insurance, marketing, advertising, and professional services such as lawyers, auditors, and accountants. It also includes travel expenses and even corporate donations to charities or non-profits.
Any office-related events such as Holiday parties, team-building events, etc., can also be classed under indirect overhead costs.
How to Calculate Overhead Costs for Your Construction Projects
Direct and indirect overhead costs have to be considered when calculating your full construction overhead.
Different methods are used to factor total overhead costs in estimating a standard overhead rate that should be charged on every project.
The total overhead cost is obtained by adding the total direct overhead costs to the total indirect overhead costs.
Determining your construction overhead and markup can be done in several ways. The most commonly used method of working out a typical contractor overhead in the United States is the Eichleay Formula.
This formula is a universally accepted method of calculating a company's daily Home Office Overhead, usually referred to as HOOH.
The Eichleay formula can be used to calculate a standard allocable HOOH value that can be charged on every project.
According to the Federal Circuit, the Eichleay formula is as follows:
- (Contract Billings / Total Billings for Contract Period) x Total Overhead for Contract Period = Overhead allocable to the Contract.
- Allocable Overhead / Days of Performance = Daily Contract Overhead.
- Daily Contract Overhead x Number of Days Delayed = Amount Claimed.
For example, let's say a company takes on a construction project that involves the following values:
- Contract Billings — $50,000
- Total Billings for Contract Period — $100,000
- Total Overhead (HOOH) During Contract Period — $15,000
- Contract Period — 3 Months
- Contract Performance Period — 91 days.
The Eichleay formula can then be used to calculate the Overhead Allocable to the project thus:
($50,000 / $100,000) x ($15,000) = $75,000
Also, the Daily Contract Overhead can be calculated as:
$75,000 / 91 days = $824.2 per day
Finally, one of the reasons why the Eichleay formula is so frequently employed is that it is helpful in the case of construction delay disputes. It can be used to calculate the amount recoverable in such a scenario.
From our example, the amount claimable for a delay of 7 days can be calculated as:
$824.2 x 7 = $5,769.4
You can tell whether your company operates with competitive overhead rates from the above calculations.
To improve the chances of winning your bids, it is best to make your overhead percentages more in tune with the general competition. It also allows you to recognize bloated operational expenses and to make the necessary cuts and budget adjustments where necessary.
However, calculating your overhead costs doesn't always have to be a long and cumbersome calculation project. Toolbox offers a charge card for construction companies. When you make purchases using the Toolbox charge card, your expenses are automatically categorized into construction-specific categories. You can simply view the categorized costs and then use the details in calculating your project overhead costs.
5 Tips to Control Overhead Costs on Your Next Project
Understanding what overhead costs typically mean and getting a glimpse of how they are calculated should give you a good idea of where your company currently stands.
To ensure sustainable practices and ideal profit margins, you need to be pragmatic in your approach to overhead costs. For example, instead of leaving your overhead rates to speculation or guesswork, you can calculate how much the company requires for expenses per project and compare it to the market average.
When you recognize that certain adjustments may need to be made for the company's survival or to increase profit margins, there are some tips that you can employ to that effect.
- Create a Comprehensive List of Overhead Expenses:
A comprehensive list of overhead costs allows you to have a clear view of all the expenses incurred by your company.
A straightforward organizational system with expenses clearly stated will make it harder to miss payments and receipts important to the company's account statements.
You can also use this to ascertain where budget adjustments need to be made.
- Make Use of Expense Management Software:
There is no better way to streamline this process than digital construction management software to create a comprehensive list of overhead costs.
Software such as Xero, Quickbooks, etc., can be used to save time and automate the process of pinpointing overhead costs and tracking the various amounts payable and receivable in the running of the business.
- Calculate your Overhead Rate:
Calculating your overhead percentage rate or Home Office Overhead is crucial to controlling your overhead costs because these are industry-specific values.
If you arrive at an amount that is way off the mark (usually at 10% overhead and 10% profit), you can instantly determine that you have to make specific changes.
- Make Smart Budgeting Decisions:
It covers a wide range of budgeting decisions that can be made to control overhead costs. Some of these decisions include:
- Choosing to purchase eco-friendly products such as LED light bulbs (to drive down electricity utility costs).
- You can also decide to use recyclables and reusable products in the office to drive down expenses further.
- Hiring multi-skilled personnel to be part of a small team. It helps reduce employee wages which are a major contributing factor to your total overhead costs.
- Renting construction equipment rather than buying them. It eliminates the cost of maintenance and repair and payment for storage spaces.
- Renting a cost-effective office space tailored to your needs in terms of size and location.
- In a company with many employees, rather than celebrating each employee's birthday separately, you can throw a party just once a month for multiple celebrants in that month.
- Take advantage of vendors' trade credit in purchasing supplies.
- Improve Your Bidding Process:
Calculating overhead costs and overhead rates can be leveraged during your consequent bidding processes. You can now factor in the direct costs for the project in addition to the standard indirect costs that you've worked out. With this, you can avoid shortchanging yourself. It also presents an excellent opportunity to forecast growth.
Final Thoughts — Overhead Costs in Construction.
Knowing how overhead costs work and how they can be classified plays a massive role in helping you control them and ultimately helping you run your business better. There are several methods on how companies arrive at the standard rate they expend in doing business.
The importance of understanding and controlling overhead costs cannot be overstated, and it is essential for the company's growth. And there's no better time to get a grip on your overhead costs than now — right before you are ready to bid on your next project.