How to Allocate Overhead Costs in Construction: A Beginner's Guide

Overhead allocation is a fundamental process in financial management for construction, manufacturing, and production-based businesses. It involves assigning indirect costs commonly known as overhead costs to products, projects, or departments. These overhead costs include expenses such as factory rent, utilities, equipment maintenance, supervisory salaries, and depreciation, which are necessary for keeping operations running but cannot be directly traced to a single product or service.

The main objective of overhead allocation is to accurately determine the total cost of producing goods or delivering services. By properly allocating overhead, companies gain a clearer understanding of their true production costs, which is essential for setting competitive prices, conducting profitability analysis, and making informed business decisions. Effective overhead allocation also helps identify areas where operational efficiency can be improved, ensuring that resources like utilities and maintenance are factored into the overall cost structure. Ultimately, a well-designed allocation process supports better decision making and long-term business success.

Table of Content:

What Are Overhead Costs in Construction?

Why Is Overhead Allocation Important?

Methods of Overhead Allocation

Departmental Overhead Rates

Factors to Consider When Allocate Overhead Costs

Conclusion

What Are Overhead Costs in Construction?

In the world of construction, where precise cost estimation is paramount to project success, overhead costs play a significant role. These expenses, often referred to as indirect costs, represent a broad category that keeps your construction business operational but aren’t directly tied to a specific project. In contrast, direct materials and direct labor are easily traced to specific projects and are included, along with overhead, as part of total product costs.

Here’s a breakdown of the two main cost categories in construction:

1. Direct Costs: 

These are expenses that can be easily traced and allocated to a specific construction project. They typically include:

• Direct Materials: The cost of raw materials like lumber, concrete, steel, and other supplies used in construction.

• Direct Labor: The wages and benefits paid to workers directly involved in building the project, such as carpenters, electricians, plumbers, and laborers. In traditional overhead allocation methods, direct labor costs are often used as a basis for allocating overhead.

• Subcontractor Costs: The fees paid to specialized subcontractors hired for specific tasks on the project, such as foundation work, roofing, or HVAC installation.

Read more: Construction Overhead Costs: Key Difference Between Direct and Indirect

2. Indirect Costs (Overhead Costs): 

These are expenses that are essential for running your business but are not directly attributable to a particular project. Overhead costs are expenses that cannot be directly traced to a single product or service, and overhead allocation is the apportionment of these indirect costs to produced goods. Overhead expenses include administrative overhead (such as office administration and sales), factory overhead (such as utilities and maintenance), indirect labor (wages for supervisors and support staff), indirect materials (supplies not directly assignable to a project), and other costs (like depreciation and insurance). Manufacturing overhead includes all indirect costs incurred during the production process. Accurate data is essential for supporting overhead allocation and ensuring precise cost calculations. They are more general in nature and benefit all projects undertaken by your company. Common overhead costs in construction include:

General & Administrative (G&A) Costs: 

These encompass expenses related to running the overall business, also known as administrative overhead, which includes costs related to non-production activities. Examples include:

• Office rent and utilities

• Insurance (general liability, worker’s compensation, etc.)

• Salaries for administrative staff (accounting, human resources, etc.)Note: Administrative expenses consist of office staff salaries, HR, and accounting fees.

• Accounting fees

• Marketing and advertising costs

• Office supplies and equipment

Jobsite Overhead Costs: 

These involve expenses specific to the construction site, including:

• Temporary facilities (portable toilets, trailers)

• Permits and licenses

• Safety equipment and supplies

• Security costs

Project Management Costs: 

These encompass salaries and benefits for project managers, schedulers, and estimators, along with project-related software and communication expenses.

Read more: Indirect Cost In Construction: What It Is and How to Streamline

Why Is Overhead Allocation Important?

Effective overhead allocation is essential for several reasons:

• Project Profitability Analysis: By allocating manufacturing overhead and manufacturing overhead costs to individual projects, you gain a clear picture of each project’s true profitability. Accurate overhead allocation is essential for determining product costs, pricing decisions, and profitability analysis. This allows you to identify areas for improvement and make informed decisions about future project pricing and bidding strategies.

• Informed Bidding: Precise overhead allocation empowers you to calculate accurate project costs and submit competitive bids. Underestimating overheads can lead to losing bids or encountering financial strain during project execution.

• Strategic Resource Allocation: Understanding overhead costs per project helps you optimize resource allocation. You can allocate resources more efficiently based on project needs and ensure your projects are adequately supported without unnecessary overhead burden.

• Strategic Decision-Making: Proper overhead allocation supports strategic decision-making regarding pricing, outsourcing, and product line rationalization.

• Cost Control and Cost-Saving Opportunities: Overhead allocation sheds light on your overall operational expenses. By identifying areas with high overhead costs, you can implement strategies to streamline operations, negotiate better rates with vendors, and ultimately reduce costs.

• Improved Financial Reporting and Decision Making: Accurate overhead allocation contributes to a more transparent financial picture of your construction business. This enables you to generate reliable financial reports for internal analysis and external stakeholders like investors or lenders.

• Risk of Poor Allocation: Poor overhead allocation can distort your cost of goods sold and lead to incorrect business decisions.

• Compliance with Accounting Standards: Generally Accepted Accounting Principles (GAAP) in the US and International Financial Reporting Standards (IFRS) require businesses to allocate overhead costs to projects in a reasonable and consistent manner.

Read more: Construction Finance: How to Manage Finance for Small Business Owners

Methods of Overhead Allocation

Several allocated overhead formula methods can be employed to allocate these costs in construction. The choice of overhead allocation method can significantly impact financial reporting and decision-making. Allocation methods can vary based on production complexity and the availability of accurate data. To calculate the overhead allocation rate, divide total overhead by the total units of the chosen base. Choosing the right method depends on the nature of your projects and your business structure.

1. Percentage of Direct Labor Hours

This method allocates overhead costs based on the total direct labor hours spent on a project. Labor cost is a key component in distributing overhead expenses, as it helps ensure accurate cost accounting and profitability analysis. This method is ideal for labor-intensive businesses, as it allocates costs based on hours worked.

Overhead Rate per Labor Hour =

(Total Estimated Overhead Costs) / (Total Estimated Direct Labor Hours)

If your company estimates $1 million in total overhead costs and 50,000 total direct labor hours for a year, the overhead rate per labor hour would be $20 (1,000,000 / 50,000). For a project requiring 1,000 direct labor hours, the allocated overhead costs would be $20,000 (1,000 x $20).

2. Percentage of Direct Costs Method

If your company estimates $1 million in total overhead costs and 50,000 total direct labor hours for a year, the overhead rate per labor hour would be $20 (1,000,000 / 50,000). For a project requiring 1,000 direct labor hours, the allocated overhead costs would be $20,000 (1,000 x $20).

Overhead Rate (%) =

(Total Estimated Overhead Costs) / (Total Estimated Direct Costs) x 100

If your company estimates $1 million in total overhead costs and $5 million in total direct costs for a year, the overhead rate would be 20%. This means for a project with $100,000 in direct costs, the allocated overhead cost would be $20,000 (100,000 x 20%).

3. Machine Hour Rate Method (Suitable for equipment-intensive projects)

Suitable for equipment-intensive projects, this method allocates overhead based on the machine time (machine hours) utilized by each project. Machine hours are a suitable basis for manufacturing companies, as they reflect the actual time equipment is in use during production. This approach ensures that projects requiring more machine time absorb a fairer share of overhead, reflecting their actual demands on resources.

Production overhead allocated using this method includes maintenance costs, equipment maintenance, depreciation, and factory supervision.

Overhead Allocation =

(Total Overhead Costs / Total Machine Hours) x Machine Hours for the Project

Example: Mulligan Imports allocates overhead to its titanium and aluminum golf shafts based on machine hours used in production. The company incurs $93,000 in overhead costs and uses a standard overhead rate of $20 per unit for its golf club shafts. If overhead costs are $100,000, total machine hours are 10,000, and a project uses 1,000 hours, the overhead allocation would be (100,000 / 10,000) x 1,000 = $10,000.

4. Activity-Based Costing (ABC)

This method, known as Activity-Based Costing (ABC), allocates overhead costs based on specific activities that drive expenses, rather than using a single volume measure. Each activity’s cost is then assigned to projects based on their usage, which requires more detailed data collection and analysis compared to traditional methods. Accurate data is essential to ensure precise cost calculations and informed decision-making.

Example: If activity analysis shows that project management consumes 40% of overhead, and a specific project requires 20% of management time, then it gets 40% of the overhead attributed to project management.

5. Square Footage Method

This method is used primarily in projects where size is a determinant factor, costs are allocated based on the square footage of the project.

Example: If total overhead is $100,000 and the total area under construction is 50,000 square feet, a project covering 5,000 square feet would bear 10% of overhead costs, or $10,000

Departmental Overhead Rates

Departmental overhead rates offer a more precise way to allocate overhead costs by recognizing that different departments within a company may incur and consume overhead differently. Instead of applying a single overhead rate across the entire company, this method calculates a unique overhead rate for each department based on its specific activities and resource usage.

For example, in a manufacturing company, the machining department might use more electricity and maintenance services than the assembly department. By assigning a separate overhead rate to each department, the company can allocate overhead costs more accurately to products or services that pass through those departments. This approach ensures that each product or project bears a fair share of the overhead costs based on the actual resources consumed, leading to more accurate costing and better financial insights for the company.

Factors to Consider When Allocate Overhead Costs

When allocating overhead costs in construction projects, consider the following factors:

• Allocation Bases: Choose appropriate allocation bases that reflect the drivers of overhead costs, such as labor hours, machine hours, or square footage. The selection of appropriate allocation bases is crucial for accurate overhead allocation.

• Cost Pools: Group similar overhead costs into cost pools to simplify the allocation process and enhance accuracy.

• Consistency: Ensure that overhead allocation methods are consistently applied across reporting periods to ensure accuracy and compliance with GAAP standards.

• Alignment with Operations: Overhead allocation methods should align with the complexity of operations and the availability of accurate data.

• Periodic Review: Regularly review and adjust your allocation methods to align with changing project dynamics and ensure accuracy.

Conclusion

Effective overhead cost allocation is essential for accurate job costing and profitability analysis in construction. By understanding and applying the correct allocation methods, construction managers can ensure financial transparency and control.

Managing overhead allocation requires precision and can be time-consuming. At Construction Cost Accounting (CCA), we specialize in providing meticulous bookkeeping services that save you time and ensure accuracy. Let us handle the complexities of overhead allocation, so you can focus on building and growing your construction business. Trust our expertise to keep your finances clear and your projects profitable.