Exploring common challenges in overhead allocation/recovery in the construction industry.
“We lost a little bit, but the job still made money.” If you are a construction business owner, and you have heard similar words from your employees in the past, you may be reaching for an antacid right now. As a business owner, you know that “making money” at the project level does not necessarily equate to a profit on the project after overhead allocation. Projects must generate marginal contributions in excess of total selling, general and administrative (overhead) costs in order for the business to generate an operating profit and produce a positive return on investment.
Creating the Right Pricing Balance
Intuitively, all contractors understand that they have to cover overhead costs for the business to break even. Operating costs, costs beyond those charged to the projects, are realities. However, how much overhead cost should you budget for at the project level? Budgeting for too much overhead can result in noncompetitive pricing. This could prove problematic for a business model that relies on continuously adding volume to an ever-evaporating back-log of work. Budgeting for too little overhead can result in negative operating profit — i.e., the marginal contribution from project revenue is less than the overhead costs of running the business. In this latter scenario, the contractor is essentially donating its equity to finance the construction project.
The question remains, “what is the right amount of overhead to allocate to each job?” Most methods of overhead allocation are based upon some relationship of overhead costs to direct costs. Theoretically, the more direct costs incurred by the project, the greater overhead resources required, and, therefore, more overhead costs are allocable to that specific project. For this article, the assumption is that contractors are accurate in their direct cost estimates, quantitative takeoffs are precise, and accurate information on production rates is readily available. If direct costs are inaccurately estimated, any application of overhead based on direct costs will be similarly inaccurate.
Many contractors “mark up” direct cost to compute the final contract amount. This markup ratio accounts for both project overhead and profit expectations. Commingling overhead and profit expectations into a single ratio is a very crude and dangerous approach. Because each project incurs overhead at a different rate, applying a single markup ratio will result in variable profit expectations to the extent that the true application of overhead varies from job to job. Profit expectations should be developed with a strategic view of the project opportunity incorporating customer relationships, competitive landscape, project risks and expected return on investment. Assume that overhead and profit are decoupled in your pricing model. At a minimum, projects must contribute enough margin to cover overhead — i.e., breakeven. Beyond covering overhead costs, projects must return operating profit to the business in order to:
- Service debt obligations and provide an acceptable equity return to investors.
- Build retained earnings to finance future growth and protect against recessionary cycles that occur in the construction industry.
The subjective portion of operating profit expectation is your anticipated equity return. Ask yourself, what is an acceptable return on my equity investment in the business? Due to the risks associated with construction, FMI argues that contractors should expect 25% to 40% returns on their investments. Think about the expected returns to alternative investments:
- Five-year average total returns for retail investments (Morningstar.com, 8/26/2015)
- DJIA 13.12%
- S&P 500 13.13%
- NASDAQ 17.26%
You can calculate your company’s return on equity by dividing net income by total net worth. Is your business realizing an acceptable return on equity? If not, you may need to consider raising your prices.
Many contractors assume that accounting for all overhead costs and acceptable profit on certain jobs will price them out of the market and that there is a certain price “that the work will go for,” regardless of margin. If the goal of the business is solely to win work and execute projects, this philosophy is sound. However, if the business truly exists to generate profits, then overhead and profitably must be stringently considered on every project opportunity. If you cannot win work at acceptable margins in your current market, you may need to consider:
- Shifting strategy and pursuing other markets
- Increasing customer selectivity within core markets
- Improving project execution
- Rightsizing the organization and reducing overhead
Another common mistake in the industry is using the terms “markup” and “margin” synonymously. Markup is the ratio of contribution margin to direct costs, while margin is the ratio of contribution margin to revenue. Because overhead costs are viewed as a percentage of revenue on common-size profit and loss statements, companies should consistently view project contribution margin as a percentage of project revenue. This means reviewing project pricing and identifying the overhead as a percentage of contract revenue. At the point of pricing work, the estimated direct costs are known, yet the intended revenue has yet to be determined. Using the income statement ratios of margin and applying those to the direct costs of the job being priced will lead to substantial underpricing of the project. For example, if a contractor has annual overhead totaling 15% of annual revenue and marks up estimated direct costs at 15% in order to break even, the contractor is only allocating 13% margin as a percentage of project revenue. This pricing approach is fundamentally structured to incur an operating loss of 2% before any profit is added to the overall price.
Overhead recovery is not optional. Overhead represents costs that are generated by the contracting process. Ideally, every single overhead expense account is individually allocable to the projects executed during the period.
Contractors must also demonstrate consistency in their costing philosophy — i.e., which costs are to be charged “above the line” (to the job) and which costs are to be charged “below the line” (to overhead). The most commonly debated cost is project management salaries. Should project manager salaries be charged to the job, or should they be considered part of overhead? Most importantly, costs should be accounted for consistently. If not, contractors run the risk of budgeting for project management wages in the direct costs and then applying an overhead rate that accounts for project management wages — essentially double counting the cost of project management for the project. This is true for all costs that lend themselves to ambiguous categorization, including estimating, engineering, purchasing, hauling and so forth. Wherever possible, FMI recommends charging costs to the project. This ensures accounting for costs in the sales/bidding process and recovering those directly through project execution. What is not acceptable is to attempt to recover those costs through overhead allocation on some jobs and through direct cost estimates on other jobs. Such lack of discipline will lead to both confusion and disappointing profit results.
The four critical factors to consider when developing a practical, usable overhead application method are as follows:
- The method should be based on a relationship among direct cost items. A direct cost is determined in the estimating process and directly charged to a project as incurred over the project’s life.
- The method should accurately match overhead costs that are incurred over the life of the project. This requires a comprehensive budgeting process to determine the overhead that will be applied to future projects.
- The method should properly match the risks and overhead costs associated with managing labor.
- The method should minimize clerical effort and other computational costs.
For construction companies that employ direct labor as “self-performing” contractors, special attention should be focused on the overhead markup and recovery process. A total direct-cost overhead recovery method or a labor-cost, markup-only process are both ineffective ways to cost and price jobs. The most accurate method of overhead recovery is the dual-overhead rate method. With this method, different markup rates for materials and direct labor are based on the company’s current operating budget. Labor represents the single largest component of risk and opportunity for profit on most construction projects. Labor will also generate the greatest amount of overhead and, accordingly, should receive the largest allocation of that overhead.
Based on many years of research on the behavior of overhead costs, the dual-rate method reflects the finding that overhead costs vary as the ratio of materials and subcontracts to labor varies. This method supports the basic theory that overhead (as a percent of total direct cost) goes down as ratio of material and subcontractors to labor goes up. The formulas for determining the dual-overhead rates are given in Exhibit 1.
The dual-overhead-rate method is so named because two different markup percentages are applied to recover overhead — one rate on labor and a separate rate on materials and subcontracts. Labor is a significant driver of overhead costs. Intuitively, this makes sense when you consider that labor requires more management time and attention than procurement of materials and subcontracts. In addition, labor management generates significant additional costs. This dual method applies one percentage markup on materials and subcontracts costs and a significantly higher markup on labor costs.
The need for such a dual rate results from the fact that different jobs use different proportions of materials and subcontracts and of labor. Jobs with low materials and subcontract-to-labor ratios have relatively low materials and subcontracts costs and, therefore, relatively high labor costs. A special condition exists with equipment- intensive contractors like highway and utility contractors. They can elect to treat equipment costs similarly to labor in these calculations with the understanding that such equipment expenses tend to generate relatively high amounts of overhead similar to labor.
The dual-rate method of overhead recovery has proven to be more accurate than any other method, and many self-performing contractors across the country have switched to this method of recovering overhead. This relatively simple method is applicable for all ranges of materials and subcontract/labor ratios. The method is limiting for large general contractors that do not self-perform work or contractors that primarily use the construction manager delivery method, namely because these contractors and types of contracts lack a significant component of labor to which overhead can be allocated.
Values for X used from Exhibit 1 are determined by the materials and subcontract-to-labor ratio and are found in the table of overhead factors in Exhibit 2. Values for overhead, labor, materials and subcontracts are provided from the company’s budgeted profit and loss statement.
The dual-overhead rates for the hypothetical contractor with the budgeted income statement in Exhibit 3 are determined as follows:
After the materials and subcontracts-to-labor ratio (M&S/L) is calculated, the overhead factors table in Exhibit 2 is consulted to find the X value of that M&S/L. For example, an M&S/L of 0.5 yields an X of 2.13, and an M&S/L of 2.0 yields an X of 3.13.
For the hypothetical contractor’s M&S/L of 2.92, the X factor must be determined by interpolation. The X factor for 2.9 is 3.72; the X factor for 3.0 is 3.80. Since 2.92 is 20% of the difference between 3.0 and 2.9, added to 2.9, the X factor for 2.92 is 20 percent of the difference between the X factors of 3.72 and 3.80, added to 3.72.
If we round to hundredths, then the X factor for an M&S/L of 2.92 is 3.74. To determine the dual rates, we need to substitute 3.74 for X and perform the calculations illustrated in Exhibit 4. Thus, the dual-overhead rates are 15.56 percent of materials and subcontracts cost and 58.2 percent of labor cost with the M&S/L of 2.92.
Applying these rates to the job examples in Exhibit 5 produces a significant improvement over other methods in matching overhead and the risk of managing labor to each particular project, as shown in Exhibit 6. This improvement is due to the recognition inherent in the dual-rate method that the creation of overhead expense is largely driven by management of labor and less so driven by material and subcontractor procurement. The other traditional allocation methods ignore this issue.
Overhead applied to Jobs A, B and C varies considerably. However, on Job B, it remains virtually the same regardless of the method. Overhead allocation to Job B remains essentially the same, because it has the same materials and subcontracts/labor ratio as the company had on its budget. Therefore, if every job had the same materials and subcontracts/labor ratio, any of these allocation methods would be accurate. Because all contractors have jobs of different materials and subcontracts/ labor ratios, the dual-rate method is more accurate than any other method in allocating overhead to these types of projects.
Using the Dual Rates
For any rate chosen, assume that the amount of overhead actually incurred in the period applies to all of the work performed in that period. Remember: Every company must calculate its own rates. Do not use any rates included in this article. Each company’s rates will be different, dependent on each company’s direct costs and overhead cost structure.
The development of an overhead rate is based on projected future costs. The best way to determine dual rates is to use a comprehensive 12-month budget tied into the fiscal year. You should recalculate rates quarterly using a 12-month rolling budget. Using a 12-month forecast minimizes seasonal influences on the cost relationships.
Whatever method you employ, a project’s risk is embedded in the additional costs it generates. Using adequate and accurate overhead recovery rates will provide a greater level of predictability for costs associated with each project. Remember that the overhead rates do not consider the desired profits, only the total cost of jobs (including overhead). Direct costs must be estimated accurately for the results of overhead application to be acceptable. However, once you are able to know these costs, you will be in a much stronger strategic pricing position and know that you are cutting into costs — instead of profits — in tight pricing situations.
Eight Steps to Apply the Dual-Overhead Rates
Applying the dual-overhead rates requires discipline and will not usually change your position in the marketplace. In addition, those idiots who do not know their costs and who insist on bidding 30% below your best price will still be in the marketplace. You cannot compete with stupid! Keep in mind that such price disparities are not always the result of stupidity but sometimes are borne of brilliance. That competitor may have actually figured out a substantially less costly way of delivering the project.
- The first step is to make sure you are using sound estimating practices. Do your projects consistently overrun estimated direct cost amounts? Do you have margin erosion on projects? Affirmative answers to these questions may be indicative of problems with your estimating, project execution or both. Sound estimating practice is your first discipline to master.
- The second step is to develop a budget for the coming year. Using the prior year history and forecast changes in the year ahead will provide a good start on the budget. FMI recommends updating budgets quarterly or semiannually to account for changing cost and volume levels in the company. In effect, you want a rolling budget that reflects the future based on the best-known information.
- Using the methodology described in the article, you can compute the dual-overhead rates. Apply these dual-overhead rates to a current estimate in your bid pipeline. This will determine the overhead that should be allocated to this project. The overhead allocation to this project calculates project breakeven (Direct Cost plus Company Overhead.)
- The next step is to add a profit and arrive at a final bid price. Profit expectations may vary when considering desirability of the project and client, time of year, availability of crews, company targeted return on investment and perceived risk. You should not bid below breakeven, but it does happen for various business reasons. The reasons are usually bad and lead to the wrong focus for projects and clients.
- DO NOT submit bids using the dua-rate method until you have reviewed the accuracy of your calculations on several “dummy bids.” Continue using your existing pricing strategy while concurrently running a dual-rate pricing strategy.
- Compare the bidding results to your existing pricing strategy for several months and note the differences and similarities. Does the dual-rate overhead method match pricing and bidding objectives more appropriately? Would you have won more work? Would you have lost projects? You will find that all three situations occur. The ultimate test is that the dual rates create a consistent pricing methodology, matching pricing to labor risk management that is a highly desirable objective. When projects are completed, would the dual-rate method have more accurately forecast overhead costs? Once you feel confident in the dual-rate method, begin using it. Always review overhead allocation from multiple angles prior to submitting your bids to ensure that there have been no errors in your calculations or assumptions.
- Constantly challenge costs and productivity to create a more cost-competitive business model. The construction industry is cost-based; driving costs down is good as long as the cuts do not compromise quality or customer service.
- Adjust your dual rates quarterly or whenever significant changes in volume/overhead occur in your company to keep the overhead allocations consistent with your current cost structure.
On average, approximately 10,000 contractors each year file for bankruptcy, according to Dun & Bradstreet. Large percentages of these contractors do not know their costs and do not add sufficient profit to their project pricing. While you have to prepare accurate estimates and be able to perform the work at the production rates in the estimate, running a profitable construction business is about more than just bidding and executing work. It is about studying the economics of your business and having an uncompromising attitude toward profit. Accurately allocating your overhead costs will bring clarity to your profit expectations and allow you to make better strategic decisions in the pursuit of work acquisition opportunities, ultimately resulting in higher profits for project and company.
Tyler Paré is a consultant with FMI Corporation. He can be reached at 813.636.1266 or via email at email@example.com.
Ken Roper is a principal with FMI Corporation. He can be reached at 303.398.7218 or via email at firstname.lastname@example.org.