Indirect Cost Allocation: Finding Your True Bottom Line

6/20/2016 - By Zachary Farrington

- This excerpt is from our Summer 2016 Dimensions Newsletter -

Most contractors are very careful to keep a close eye on project costs such as labor and materials. But direct job costs like these are only part of the picture.

It is equally important to have a clear understanding of indirect costs such as rent, utilities, taxes and insurance. These costs must be accurately and consistently allocated among the various projects the company undertakes.

Determining the proper allocation of indirect costs can be a complicated process – but a very necessary one. Accurate cost allocation helps give management a clear understanding of the company’s true bottom-line performance and the actual profitability of individual projects. It also is required by nearly all lenders and sureties, who expect to see financial statements that are compliant with generally accepted accounting principles (GAAP).

Bear in mind that a cost allocation method that is GAAP-compliant is not necessarily the correct method to use for tax purposes. GAAP and tax accounting can be two very different functions so the GAAP methods discussed here are not necessarily the correct methods to use for tax compliance.

Identifying Indirect Costs
The first step is to identify which indirect costs are to be allocated among the company’s various projects. These would include any production-related costs that are incurred on a company-wide basis and cannot be traced directly to a specific project.

Common examples include rent, utilities, depreciation and similar costs associated with production facilities such as storage buildings or assembly plants. Other costs that are typically allocated include depreciation, repairs and maintenance of equipment and vehicles that are used company-wide, rather than being assigned exclusively to one project.

General project management and supervision, quality control and inspection, small tools and general construction supplies are also considered indirect costs. Contractor’s liability insurance, some employee payroll taxes, workers compensation insurance and other benefit costs should also be allocated.

Note that it may not be appropriate to include certain general and administrative (G&A) costs, such as salaries for administrative personnel whose duties are not actually related to the construction process. Most of today’s construction accounting software can discern such personnel-related costs and allocate them appropriately.

Creating Cost Pools
The various indirect costs are then aggregated into designated cost pools. These are groups of related costs that can be allocated equitably to the various projects. In some companies, all the indirect costs can be grouped into a single cost pool. In others, grouping all costs together could produce a misleading picture of each project’s profitability.

For example, if a highway and heavy equipment contractor subcontracts out some of its work to other companies, its own equipment is not used. To avoid overcharging company-wide equipment costs to projects where equipment is not used, the company would create a separate pool for equipment-related costs and allocate them accordingly.

Choosing an Allocation Method
With the indirect cost pools established, the next challenge is to determine a method for allocating those costs equitably across all projects. Every company’s cost structure is unique, so no single method is right for every contractor.

The most common method bases the allocation on direct labor costs or hours. In theory, the direct labor costs for each project are compared the company’s total direct labor costs for the year. The indirect costs are then allocated using the same ratio.

As a practical matter, contractors typically look back over the previous year and calculate a burden rate (a set amount per labor hour) that reflects this ratio. This burden rate is then applied against the job as direct labor costs are incurred. When work is assigned to subcontractors rather than self-performed, direct labor costs do not provide an accurate basis for indirect cost allocation. So many contractors develop more sophisticated allocation formulas that factor in material costs or other significant cost drivers.

A Rational, Systematic Approach
Regardless of which drivers and formulas are chosen, the burden rate and overall cost allocation methodology should be reviewed on an annual basis (at a minimum) to verify it is still accurate and appropriate to your company’s situation.

Above all, it is important to develop a GAAP-compliant method that is rational and suitable for your situation and then apply that approach systematically and consistently, year after year.