How to calculate overhead rate in construction
- Irvine Bookkeeping
- May 3, 2024
- 8 min read
Updated: Sep 29
Construction finances involve mastering various concepts. Especially in the intricate landscape of construction finances, the overhead cost is one of the crucial aspects. Whether a seasoned contractor or a newcomer in the field, comprehending how to calculate the overhead rate is necessary for successful project management and financial stability.
In this post, we'll discuss the construction overhead, exploring its definition, and importance, and how to calculate it effectively to bolster your construction business's profitability
TABLE OF CONTENT
What Is Construction Overhead?
Construction overhead refers to indirect expenses that support project execution but cannot be directly assigned to a specific job.
Typical examples include:
Administrative salaries & office staff
Rent, utilities, and office supplies
Insurance, legal, and professional fees
Equipment depreciation, vehicles, and maintenance
Licenses, taxes, and other recurring business costs
Why Is Overhead Rate Calculation Important?
Accurate Cost Estimation: By factoring overhead expenses into project costs, you can ensure more precise budgeting and cost estimation, minimizing the risk of financial discrepancies during project execution.
Profit Margin Analysis: Understanding the overhead rate allows construction companies to determine the ideal profit margins for their projects. Ensuring profitability while remaining competitive in the market.
Strategic Decision-Making: Construction managers can make informed decisions regarding resource allocation, pricing strategies, and business expansion initiatives. Managing overhead costs and identifying significant costs are crucial for business growth and long-term success.
Read More: Job Costing Essentials for Contractors
Types of Construction Costs and Expenses
Before learning how to calculate the overhead rate, it’s important to understand the two main types of construction costs. The first is direct costs, which include project-specific expenses such as labor, materials, and equipment. The second is indirect costs, often called overhead, which cover expenses that support the business but cannot be linked to a single project, such as rent, insurance, and administration. Some construction companies also allocate overhead on a project-by-project basis to achieve more accurate estimates.
Direct Costs:
Direct costs, also known as direct expenses, are project-specific costs directly attributable to specific construction projects. These include items such as labor, materials, and equipment, and are often referred to as job costs. Direct costs are distinct from overhead costs, which are not tied to a single project.
Examples of direct costs include:
Labor Costs: Wages, salaries, and benefits for on-site workers, subcontractors, and project managers, often outlined under different types of construction billing contracts.
Material Costs: Expenses related to purchasing construction materials such as lumber, concrete, steel, and fixtures.
Equipment Costs: Rental or purchase costs for machinery, tools, and equipment used in project execution.
Subcontractor Fees: Payments to external contractors hired to perform specialized tasks or trades.
Permit and Inspection Fees: Costs associated with obtaining necessary permits and complying with building codes and regulations.
Direct Overhead Costs: Project-specific overhead expenses such as temporary office space required for the duration of the project.
Indirect Costs (Overhead):
Indirect costs, also known as overhead expenses, are incurred for the overall operation of the construction business and cannot be directly attributed to specific projects. These include:
Indirect overhead costs such as administrative expenses and office support
Rent for office space and other facilities
Benefits and salaries of full-time employees
Insurance costs, including general liability coverage and workers compensation insurance
Bonding and insurance expenses, such as bonding premiums and insurance premiums
Payroll taxes and other labor related costs
General liability coverage
Transportation costs
Labor hours
Utilities like electricity, gas, and water
Government fees and licenses
Taxes on property, land, or other assets
Depreciation costs
Maintenance costs
Other job costs
How to Calculate Overhead Rate in Construction?
Accurately calculating overhead and establishing appropriate overhead rates are essential for precise project cost estimation and effective budgeting in construction. Understanding overhead costs in construction helps ensure all indirect expenses are properly managed and allocated.
Now, let’s delve into the step-by-step process of calculating the overhead rate in construction:
Identify Total Overhead Costs: Begin by identifying and summing all total overhead costs, including administrative expenses, insurance, equipment, and other indirect costs associated with running your construction business.
Allocate Overhead Costs: Calculating overhead costs involves allocating these total overhead costs to each project. For complex projects, more detailed and adjusted overhead calculations may be necessary to ensure accuracy.
Calculate Overhead Rate: The overhead rate is typically calculated as a percentage of total project cost or total direct costs. This helps you determine how much overhead should be applied to each project.
Apply Overhead Rate: Once calculated, apply the overhead rate to your current and future projects to improve cost estimation and financial planning.
Alternative Method – Total Project Estimate Minus: Another approach is the 'total project estimate minus' method, where you subtract overhead, material, and labor costs from the total project estimate to determine profit margins and ensure all costs are covered.
By following these steps for calculating overhead, you can avoid common mistakes, improve project profitability, and maintain better control over your project cost and budgeting.
Step 1: Identify Overhead Expenses
Begin by compiling a comprehensive list of all indirect expenses incurred by your construction business. This includes items such as office rent, utilities, administrative salaries, insurance premiums, and equipment maintenance costs. Identifying specific overhead costs is crucial to ensure you can accurately allocate overhead costs to each project. Properly allocating overhead costs not only improves job costing and profitability analysis but also supports efficient business operations by streamlining financial tracking and project management. This entails compiling a comprehensive list of indirect costs, which may include but are not limited to:
Step 2: Calculate Total Overhead Expenses
Total the indirect costs identified in Step 1 over a specified period, typically a month or a year. Be sure to include all the costs listed in Step 1 to accurately determine your total overhead costs. This figure represents the total overhead expenses incurred by your construction business during the designated timeframe.
Rent for Office Space and Other Facilities
Benefits and Salaries of Full-Time Employees
Insurance Coverage
Transportation Costs
Labor Hours
Utilities
Government Fees and Licenses
Taxes
Depreciation Costs
Maintenance Costs
Other Job Costs
Step 3: Determine Direct Costs
Next, ascertain the total direct costs, also referred to as direct expenses, associated with your construction projects. Direct costs (or direct expenses) encompass expenses directly attributable to specific projects, such as labor, materials, subcontractor fees, and equipment rentals.
Step 4: Compute the Overhead Rate
Once you have the total overhead expenses and direct costs, you can calculate overhead costs by determining the overhead rate. Overhead rates are typically calculated as a percentage of the total project cost, allowing you to accurately allocate indirect expenses to each construction project. Use the following formula:
Step 5: Method for Allocating Overhead: Rate of Direct Costs & Proportion of Direct Job Costs
After computing the overhead rate, the next crucial step is to allocate overhead costs to each specific project accurately. This process of overhead allocation enables construction businesses to report profit and loss on a more granular level, providing enhanced visibility into cost structures and project profitability.
Overhead Allocation Methods:
One common method is the rate of direct costs, where a fixed percentage of total direct costs is applied to each project. This allows construction firms to spread overhead proportionally, reflecting the size and complexity of the job. Project-specific overhead, such as equipment rentals or temporary utilities, should also be identified and assigned directly to ensure accurate costing.
Another approach is the proportion of direct job costs, which allocates overhead based on each project’s share of total direct costs. This method offers a more tailored distribution and can improve the precision of project estimates.
Step 6: Interpret and Apply the Overhead Rate
Once you’ve computed the overhead rate, interpret the results to gain insights into your business’s financial health. A higher overhead rate indicates that a larger portion of your revenue is allocated towards indirect expenses, while a lower rate suggests more efficient cost management.
Applying the calculated overhead rate to future projects can improve cost estimation and financial planning.
Managing Recurring Expenses in Construction Overhead
Effectively managing recurring expenses is a cornerstone of controlling overhead costs for construction businesses. Recurring expenses—such as office rent, utilities, and insurance—can quickly add up and erode profit margins if left unchecked. Construction companies should make it a routine practice to review all ongoing contracts, from office leases to service agreements, and seek opportunities to renegotiate terms or secure better rates.
Implementing cost-saving measures, like switching to energy-efficient lighting or consolidating office supply orders, can further reduce these ongoing overhead costs. Leveraging accounting software is another smart move, as it allows construction businesses to track recurring expenses in real time, set alerts for contract renewals, and analyze spending patterns. By staying proactive and vigilant, construction companies can keep their overhead costs in check, freeing up more resources for direct project expenses and ultimately boosting their profit margins.
Handling Reimbursable Expenses
Reimbursable expenses—like mileage, equipment rental, and project-specific costs—are a key part of construction overhead. Construction companies should track these expenses using software or standardized forms and conduct regular audits to ensure all costs are captured. Clear contract terms on reimbursables help clients understand which costs are covered. Accurate and transparent management of reimbursable expenses reduces financial leakage, maximizes cost recovery, and strengthens profit margins.
Project Costs, Overhead, and Profit Margins
Construction businesses must grasp how project costs, overhead, and profit margins interact. Direct costs like labor, materials, and equipment, combined with indirect overhead, determine true project expenses. Accurate tracking and allocation of overhead—based on project size or resource use—ensures realistic pricing and profitability. Job costing software provides real-time insights, helping companies monitor performance and adjust strategies. Mastering these relationships safeguards profit margins, supports informed decisions, and strengthens competitiveness in the construction industry.
Examples and Practical Tips
To illustrate the concept of overhead rate calculation, let's consider a hypothetical scenario
Example: ABC Construction Company incurs $50,000 in overhead expenses and $200,000 in direct costs over the course of a year.
Using the formula:
Overhead Rate= 50,000/200,000×100=25%
In this scenario, ABC Construction's overhead rate is 25%, implying that for every dollar spent on direct costs, an additional 25 cents is allocated towards covering overhead expenses.
Practical Tips:
Regular Expense Tracking: Implement robust bookkeeping and accounting practices to track overhead expenses meticulously, ensuring accuracy and transparency in financial reporting.
Calculating Overhead: Regularly calculate overhead using established methods to ensure precise allocation of indirect costs. This supports efficient business operations and helps avoid common mistakes that can impact profitability.
Managing Overhead Costs: Actively manage overhead costs by tracking indirect expenses, utilizing management tools, and implementing cost-saving strategies to improve profitability and operational efficiency.
Efficiency Optimization: Continuously evaluate operational processes and identify opportunities to streamline workflows and reduce overhead costs without compromising quality or safety standards.
Benchmarking and Analysis: Compare your overhead rate to industry benchmarks to gauge your business’s competitiveness. Besides that, need to identify areas for improvement.
Read More: Best Practices for Construction Accounting
Conclusion: Empowering Your Construction Business
In conclusion, mastering calculating the overhead rate is instrumental in optimizing a construction business's financial performance. By usually tracking overhead expenses, analyzing profit margins, and making informed strategic decisions. Businesses can position their construction firm for success and long-term sustainability in a competitive market landscape.
Irvine Bookkeeping for tailored construction bookkeeping services. Our certified QuickBooks and Sage experts bring precise, efficient financial management to your business. Partnering with us gives you access to skilled professionals who streamline your operations and enhance growth, allowing you to focus on core competencies like project management and client relations. Trust Irvine Bookkeeping for cost-effective, expert solutions.
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