Previously, I wrote about the importance of maintaining a good set of accounting records.
In this post, I want to expand on that and write about the importance of proper job costing and accurate estimates.
The most important decision a contractor will ever make is how to price out their construction contracts in order to make the most money. This can be accomplished by tracking the true costs to deliver the contract and adding to those costs the contractor’s target gross profit margin.
There are three different components of your costs that need to be looked at in order to determine the best price for the contract.
1. Direct costs
First, a contractor should consider their direct costs associated with performing the contract.
Those direct costs of a specific contract consist of:
- – Direct labor and associated labor costs (wages, workers compensation insurance, fringe benefits and payroll taxes)
- – Direct materials bought
- – Subcontractor costs
- – Equipment rental
- – Any other job costs that can be identified to a specific contract
2. Indirect costs
Second, a contractor should consider their indirect costs associated with performing the contract.
These costs consist of:
- – Insurance (general liability insurance and other insurances that are not job specific)
- – Equipment owned and small tools (costs to maintain and insure the equipment and small tools owned by a contractor)
- – Indirect labor and associated labor costs (wages , workers compensation insurance, fringe benefits and associated payroll taxes of employees, such as project managers and superintendents, who help complete contracts, but are not costed to a specific contract)
- – General conditions (rental of office trailers, general supplies and any other job costs that can’t be identified to a specific contract)
These costs need to be allocated before adding to the direct job costs. Common methods used to allocate indirect costs are based on:
- – Direct labor costs associated with a contract (this is the most common method that I have seen)
- – Direct materials associated with a contract and specifically allocating equipment costs based on equipment hours
It is imperative that a contractor include indirect costs in their estimating and bidding process. Keeping track of these costs can be time-consuming and tricky, but understanding these will help a improve margins and provide better estimates of a contract spend.
3. Overhead costs
Finally, as part of the estimating process, a contractor will need to determine their overhead costs such as administrative staff, office rent, management staff, marketing costs and other necessary expenses required to run a contractor business.
The gross profit on each contract (revenue less direct and indirect job costs) will need to be enough to cover the overhead costs and generate a bottom-line profit.
The best way to include these costs in the estimating process is to develop a rate based on direct labor hours that includes a profit and overhead costs.
This rate can be determined by figuring the total annual overhead costs and dividing that amount by the total direct labor incurred on all contracts annually.
Rate = total annual overhead costs ÷ total annual direct labor costs of all contracts
This amount will fluctuate based on the amount of contracts worked in any given year and should be revisited annually.
The competitive bid environment leaves little room for error in estimating. A proper estimate can only be accomplished by first having a strong grip on your direct job costs and confidence in your cost allocation and indirect costs rate.
These pillars will only serve to strengthen your financial foundation and provide a more reliable future for your business.
Adriane Shaffer is a licensed CPA with over 20 years of experience. She specializes in working with small to mid-size companies in the New York City and New Jersey regions. Her industries of expertise include construction, real estate, medical practices and wholesale distribution. She got her bachelor’s degree in accounting from Rowan University.