Overhead Cost Allocation in the Construction Industry

In the fast-paced and competitive construction industry, managing costs effectively is crucial for success. One critical aspect of cost management is overhead cost allocation. In this article, we will delve into the significance of overhead cost allocation for construction companies and explore effective strategies to optimize this process.

Overhead costs, also known as indirect costs, are those costs that are not directly related to the production of a product or service. These include costs such as rent, utilities, administrative costs and salaries and insurance. Overhead costs are essential for running a successful business, but it can be difficult to accurately allocate them across multiple projects and departments. In the construction industry, overhead cost allocation is particularly challenging due to the complexity of the projects and the diverse range of resources required.

Measure Your Business Success With job Costing

Take the first crucial step towards becoming a construction accounting expert through Construction Accounting University.

Watch On-Demand Now

In the construction industry, several overhead costs are commonly incurred by companies. These costs are indirect expenses that are not directly attributable to a specific project but are necessary for the overall operation and management of the construction business. Here are some of the most common overhead costs in construction:

1. Office expenses: These include costs related to maintaining and operating the company's administrative expenses, such as rent, utilities, office supplies, equipment and communication expenses.
2. Salaries and benefits: Construction companies typically have staff members who work in administrative roles, such as project managers, estimators, accounting professionals and support staff. The salaries, wages and benefits of these employees form a significant portion of overhead costs.
3. Insurance: Construction projects involve inherent risks, and insurance coverage is essential to mitigate these risks. Overhead costs may include premiums for general liability insurance, workers' compensation insurance, builder's risk insurance and professional liability insurance.
4. Depreciation: Construction companies utilize various equipment, machinery and vehicles necessary for project execution. Over time, these assets depreciate in value. The portion of depreciation attributed to these assets is considered an overhead cost.
5. Licenses and permits: Obtaining licenses and permits is a necessary part of operating in the construction industry. Overhead costs include expenses associated with acquiring and renewing licenses, building permits, zoning permits and other regulatory compliance costs.
6. Professional services: Construction companies often seek external professional assistance from consultants, lawyers, accountants and other experts. The fees paid for these services are considered overhead costs.
7. Marketing and advertising: To attract clients and promote their services, construction companies invest in marketing and advertising activities. These costs encompass advertising campaigns, website maintenance, brochures, trade show participation and other marketing initiatives.
8. Training and development: The construction industry is continually evolving, and companies need to invest in employee training and development programs. Overhead costs may include expenses related to seminars, workshops, certifications and other educational opportunities.
9. Software and technology: Construction companies rely on various software and technology tools to streamline operations, manage projects and enhance efficiency. Overhead costs may include expenses for project management software, construction accounting software, CAD programs and other technology solutions.
10. Safety equipment and training: Safety is paramount in the construction industry. Overhead costs may include investments in personal protective equipment (PPE), safety training programs, safety signage and other safety-related expenses.

It's important to note that the specific overhead costs may vary depending on the size of the construction company, the scope of projects undertaken and other factors. 

Overhead cost allocation is the process of assigning a portion of the overhead costs to each project or job. This helps construction companies accurately track and measure their expenses, enabling them to make good business decisions and maximize profits by setting reasonable prices for their services and preventing costly errors. 

Why is Overhead Cost Allocation Important?

Allocating overhead costs accurately is essential for ensuring that all departments and projects are charged fairly for their share of indirect costs. This helps to ensure the equitable distribution of resources, increases accountability and prevents overspending in certain areas. In addition, accurate overhead cost allocation can help to identify areas where costs can be reduced and provide insights into potential areas of improvement.

Several factors can influence overhead cost allocation in the construction industry. It's important to consider these factors to ensure that the allocation method used accurately reflects the drivers of overhead costs. Here are some common factors that can affect overhead cost allocation in construction:

1. Project characteristics: The characteristics of a construction project, such as its size, complexity, duration and location, can impact the allocation of overhead costs. Large-scale and complex projects may require more resources and overhead allocation compared to smaller, straightforward projects. Projects located in remote areas or with unique logistical challenges may have specific cost drivers that need to be considered.
2. Cost structure: The cost structure of a construction company, including the proportion of direct costs to indirect costs, can affect overhead cost allocation. Companies with higher indirect cost ratios may need to allocate more overhead expenses to each project to ensure accurate cost recovery.
3. Organizational Structure: The organizational structure of a construction company can influence overhead cost allocation. Companies with multiple divisions, departments or subsidiaries may need to allocate overhead costs differently based on the activities and responsibilities of each unit. A centralized or decentralized structure can impact how overhead costs are assigned to projects.
4. Cost accounting system: The design and functionality of the cost accounting system used by the construction company play a crucial role in overhead cost allocation. The system should be capable of capturing and tracking overhead costs accurately and providing relevant data for allocation purposes, all while giving you the flexibility to go back and adjust your estimated rates. It should also integrate with project management and financial systems to ensure seamless information flow.
5. Allocation methodology: The chosen overhead cost allocation methodology and allocation bases can significantly impact the accuracy of cost allocation. Different allocation methods, such as direct labor hours, direct labor costs, square footage or equipment usage, may be suitable for different types of projects or overhead cost categories. It is essential to select the most appropriate methodology and regularly review and adjust it if necessary.
6. Joint or shared projects: In situations where multiple projects share common resources or overhead costs, the allocation process becomes more complex. Proper allocation mechanisms should be established to distribute shared costs fairly among the projects involved. Factors such as project size, resource usage or revenue generation may influence the allocation formula.
7. Regulatory and contractual requirements: Compliance with regulatory and contractual obligations may impact how overhead costs are allocated. Some contracts or regulations may have specific requirements or restrictions regarding the allocation of certain types of overhead expenses. It is crucial to understand and adhere to these requirements to ensure compliance.
8. Technological advancements: Technological advancements in construction, such as the use of Building Information Modeling (BIM), construction management software or project tracking systems, can provide more accurate data for overhead cost allocation. Leveraging these technologies can enhance the efficiency and accuracy of the allocation process.

It is essential for business owners to carefully consider these factors when determining their overhead cost allocation methods. By understanding the specific drivers and circumstances affecting overhead costs, companies can allocate expenses more accurately, leading to improved project costing, profitability analysis and cost control.

In the construction industry, effective overhead cost allocation is crucial for accurate project costing and improved profitability. There are various methods that construction companies can utilize to allocate overhead costs. This article explores the traditional methods, the activity-based costing (ABC) approach, as well as hybrid approaches and industry best practices.

Traditional methods of overhead cost allocation

1. Direct labor hours or labor costs: This method allocates overhead costs based on the direct labor hours spent on a project or the direct labor costs incurred. It assumes that overhead costs are directly related to labor activities and uses labor as the allocation base.
2. Square footage or floor area: Allocating overhead costs based on the square footage or floor area of a project assumes that larger projects consume more resources and incur higher overhead costs. This method is commonly used in construction projects where space utilization is a significant cost driver.
3. Equipment usage or depreciation: For construction companies heavily reliant on equipment, allocating overhead costs based on equipment usage or depreciation can be effective. This method considers the hours of equipment usage or the depreciation value as the allocation base.

Activity-Based Costing (ABC) Method

1. Understanding activity centers and cost drivers: ABC involves identifying the specific activities (activity centers) within the construction process and the cost drivers associated with each activity. This approach aims to link overhead costs directly to the activities that cause them.
2. Allocating overhead costs based on activities and their drivers: In ABC, overhead costs are allocated based on the consumption or demand placed on specific activities. The cost drivers, such as the number of inspections conducted, the number of change orders processed, or the complexity of project management, help determine the allocation of overhead costs.

Hybrid Approach

To achieve more accurate overhead cost allocation, construction companies often employ hybrid approaches that combine elements of traditional methods and ABC. These approaches take into account multiple allocation bases and incorporate industry best practices. By tailoring the allocation methods to the specific needs of the company and projects, hybrid approaches provide a more comprehensive and accurate picture of overhead cost allocation.

Allocating overhead costs in a job costing system involves assigning indirect expenses to specific jobs or projects based on a predetermined allocation method. This process helps determine the true cost of each job and enables accurate pricing, profitability analysis and informed decision-making. Here are the steps to allocate overhead costs in construction job costing software:

1. Identify and classify overhead costs: Begin by identifying and categorizing the various overhead costs incurred by your business. These may include rent, utilities, administrative salaries, equipment depreciation, maintenance, insurance and other indirect expenses. Classify these costs into appropriate categories for easier allocation.
2. Determine allocation base: Select a suitable allocation base that reflects the consumption or driver of overhead costs in your business. Common allocation bases in job costing systems include direct labor hours, direct labor costs, machine hours or material costs. The allocation base should be closely related to the cause of the overhead costs being allocated.
3. Calculate overhead rate: Calculate the overhead rate by dividing the total overhead costs for a specific period by the total quantity of the chosen allocation base. For example, if your total overhead costs are $100,000 and the total direct labor hours for that period are 5,000, the overhead rate per direct labor hour would be $20 ($100,000 / 5,000 hours).
4. Assign overhead to jobs: Once you have determined the overhead rate, you can allocate overhead costs to individual jobs based on their consumption of the allocation base. Multiply the allocation base for each job by the overhead rate. For example, if a job requires 100 direct labor hours, the overhead allocation for that job would be $2,000 ($20 per hour x 100 hours).
5. Review and adjust allocation method: Regularly review the allocation method and its effectiveness. Consider factors such as changes in business operations, technology advancements or shifts in cost structure that may impact the accuracy of your allocation. Adjust the allocation method as necessary to ensure it aligns with the evolving needs of your business.
6. Document and track costs: Maintain detailed records of overhead costs, allocation bases and the rationale behind allocation decisions. Accurate documentation ensures transparency, facilitates auditing processes and enables future analysis and improvement of allocation methods.
7. Utilize technology solutions: Leverage construction accounting software or enterprise resource planning (ERP) systems like Deltek ComputerEase to streamline the overhead cost allocation process. These tools can automate calculations, track costs, generate reports and provide real-time visibility into job overhead expenses.
8. Monitor and analyze results: Regularly monitor the allocated overhead costs for each job and compare them to the actual overhead expenses incurred. Analyze any significant variances and investigate the reasons behind them. This analysis helps refine future allocation methods and improve the accuracy of job costing.

Remember, the key to successful overhead cost allocation in a job costing system is selecting an appropriate allocation base and regularly reviewing and adjusting the allocation method. By accurately allocating overhead costs, you can better determine the profitability of each job, make informed pricing decisions and enhance overall cost control in your business.

Accurately Allocate Overhead Costs with Deltek ComputerEase

Take your business to the next level with Deltek ComputerEase, the industry-leading accounting software for construction.

Request Your Demo