If you own a building business, you probably know what "overhead cost" means. But what is an overhead cost, and why is it important in the building business? This blog will provide insights into the meaning of overhead costs, how to calculate them, and why they're vital for your business's profitability.
What is Overhead Cost?
Overhead costs refer to an ongoing expense. This expense is not tied to a specific project. Instead, it supports your business's overall operation. Examples of overhead costs include office rent, utility bills, and insurance. Even salaries for non-project staff fall into this category. Overhead costs are crucial for your profit margin. If you don't keep track of your costs, you might not be making as much money as you think.
Why Contractors Need to Calculate Overhead Costs
As a construction project manager, you manage budgets regularly. Therefore, you need to understand all the costs associated with a project. This understanding helps you stay on budget. However, overhead costs often get overlooked or underestimated. This oversight can lead to cost overruns and schedule delays.
Think about this scenario: You could be losing money on a project without realizing it. This loss can happen if you haven't calculated your overhead. If you are operating on particularly lean margins, it's even more likely.
Calculating overhead costs gives you a clear picture of your project's true cost. It helps you understand if a project is profitable or not. Not only does it tell you how your current project is going, but it also gives you information you can use for future tasks. Accurate overhead cost calculations are a proactive way of preventing losses and ensuring profitability.
Again, this may seem hard, and it can be, but there are ways to deal with it. Construction Cost Accounting (CCA) is here to help. Our construction bookkeeping services will assist you in accurately tracking your overhead costs. This service leaves you free to focus on what you do best: building and managing construction projects. With CCA, you have a trusted partner in ensuring your financial health.
Breaking Down Construction Overhead Costs: Direct vs. Indirect
Overhead costs in construction can be categorized into two types: direct and indirect overhead costs. Let's examine both for a clearer understanding.
Direct Overhead Costs
Direct overhead costs are expenses tied to a specific project. But they're not costs for labor or materials. They are needed for the project but not tied to a particular job within it. Examples of direct overhead costs include:
Job site utilities: Utilities for the project site, such as water and electricity.
Equipment rental: The cost of renting equipment specifically for the project.
Job site supervision: Salaries for supervisors and project managers overseeing the project.
Temporary structures: Costs for constructing temporary facilities like site offices or storage units.
Depreciation: The depreciation of the machinery and equipment used on the project.
Indirect Overhead Costs
Indirect overhead costs are expenses needed to run your business. They're not tied to any specific project. Even if there were no ongoing projects, you'd still have these costs. Examples of indirect overhead costs include:
Administrative expenses: This includes office rent, utilities, insurance, salaries, and professional fees.
Insurance and licenses: the cost of business insurance, professional licenses, and bonding.
Professional fees: Fees for professional services, like accounting or legal advice
Equipment expenses: These are costs for leased and owned equipment, maintenance, and repairs.
Vehicle expenses: This covers leased and owned vehicles, fuel, and maintenance and repairs.
Labor Overhead and its Significance
Labor overhead is another vital aspect. It covers indirect costs associated with employees. Examples include health insurance, retirement contributions, and taxes. Understanding labor overhead is critical for calculating the overhead percentage. This figure shows your business's financial health.
Transitioning to Overhead Cost Calculation
Keep in mind that not all costs are overhead. Costs that are directly linked to the project's work, such as labor, materials, and direct expenses, do not count as overhead costs.
So, how do you calculate overhead costs? First, identify all the indirect costs related to each project. These costs are your overhead. Just like work has specific codes, there are also particular codes for overhead costs. These codes help you allocate these expenses properly.
While your accounting software can do most of this work, it's crucial that you understand these overhead costs. They play a vital role when you estimate your project's profit.
Now let's take a look at how to calculate these overhead costs. It might sound complex - but do not worry. We're here to guide you.
How to Calculate the Overhead Percentage
The overhead rate, sometimes referred to as the overhead percentage, reflects how much your business spends to deliver its services or make its products. Here's how to calculate it:
Total Your Overhead Costs: Gather all the indirect costs your contracting business incurs over a specified period, usually a month. These overhead costs may include office rent, marketing expenses, and administrative staff salaries.
Determine Your Sales Figures: Total the revenue your contracting business earned over the same period.
Calculate Your Overhead Percentage: Use this simple formula:
Overhead Percentage = (Total Overhead Costs / Total Sales) * 100
For instance, if your overhead costs are $120,000 and your total sales are $800,000, your overhead percentage would be ($120,000 / $800,000) * 100, which is 15%. This means that for every dollar your contracting business makes, 15 cents are used to cover overhead costs.
You can also compute your overhead percentage in relation to labor costs by replacing total sales with total labor costs in the formula above.
Remember, a lower overhead percentage implies a more efficient use of resources.
Understanding this overhead rate is key. It gives you a clearer picture of how much you're really spending on each project. It also helps you price your services accurately to ensure you're making a profit.
Understanding overhead costs is crucial for any construction business owner. By accurately tracking and managing these costs, you ensure your business stays profitable. CCA can help navigate the complexities of construction bookkeeping. So, you can focus on building and managing your projects. Let's get in touch today. Visit our contact page or schedule a 15-minute meeting with us.