Overhead costs in construction can be a heck of a thing to pin down. On the surface, it looks simple: Overhead is the cost of doing business. But in reality, there are several types of overhead costs. Rather than lumping the types into one arbitrary construction overhead percentage and tacking it onto every bid, they need to be accounted for separately — and they often use different calculations.
Sounds intimidating, right? It doesn’t have to be. This guide will help explain the different types of overhead and how to calculate them. There are even a few tips concerning lessening your overhead, so you can run a more streamlined, profitable business, and bolster your bidding practices.
Direct vs. indirect overhead
For some companies, calculating overhead consists of materials, tools, vehicle costs, travel, insurance, and the cost of shop rent or mortgage. Unless you’re a very small (like, one-person small) outfit tackling small renovations, there are important and expensive costs left out of that equation.
There are two different types of overhead costs in construction: direct and indirect. Direct overhead costs are generally the easiest to calculate. These are the costs that are directly relatable to a specific project. Indirect costs are the behind-the-scenes costs that you can’t attribute to just one job, and they’re often the reason for inaccurate bids and lower-than-expected profit margins.
Direct expenses
Direct expenses are typically the easiest types of construction overhead costs to nail down, as they’re related to one specific project. For example, all of the materials used for a project are direct costs. The cost of the equipment rental, labor, parking fees, permits, subcontractors, court fees, fines, mobilization costs, and anything related to just one project are direct expenses.
That’s fairly simple, right? The next type of overhead isn’t always as straightforward.
Indirect expenses
Now that you have a handle on direct expenses, determining which costs are indirect is a bit easier. But it’s important not to miss anything; else, your year-end profit might not hit your projections.
Indirect expenses include things that aren’t allocable to just one project. For example, the salaries of office staff, the costs of marketing, office supply orders, cell phones, vehicle costs, uniforms for staff, equipment purchases (in most cases), office parties, equipment/PPE/tool allowances, rent for storage, and holiday bonuses are indirect expenses. And that’s just a few of these indirect construction overhead costs.
Dive deeper: How to Assess & Manage Indirect Costs in Construction
Careful — direct and indirect costs aren’t always clear
Things can get tricky, too. For example, some smaller specialty shops bulk order their materials to take advantage of pricing and avoid delays. If they don’t break them up into accurate direct costs for each project, the order becomes an indirect cost that they can’t account for accurately. This leads to inaccurate bidding and lost profits.
Also, consider interest rates. If you’re financing materials, you can easily contribute the costs of the individual materials or tools, but are you accounting for the interest paid on them? Will you attribute 12 months of financing charges on a project’s materials or equipment to a project that only took 3 months to complete? Interest might not make up the lion’s share of construction overhead percentage, but it’s worth thinking about.
How to calculate overhead costs
Construction overhead costs need to account for direct and indirect costs. The overarching formula is simple: direct costs plus indirect costs equals construction overhead cost. But determining the construction overhead percentage attributable to indirect costs can be a challenge.
The Eichleay Formula
In order to truly nail down typical contractor overhead and profit, construction companies need to get a real handle on their Home Office Overhead, or HOOH for short. One of the most universally accepted methods for calculating HOOH is The Eichleay Formula.
The Eichleay Formula uses company revenue to determine a daily HOOH value and provide an allocable HOOH amount for a project. Stick with me here; it’s worth learning.
Let’s work with round numbers, for simplicity’s sake:
- Contract Period: 3 Months
- Contract Billings: $300,000
- Total Company Billings Over Contract Period: $600,000
- HOOH During Contract Period: $90,000
- Contract Performance Period: 92 Days
The Eichleay Formula uses these values to determine the HOOH allocable to a given project:
(Contract Billings/Total Company Billings Over Contract Period) x (HOOH During Contract Period)=Allocable HOOH to Project.
For our example: ($300,000/$600,000) x ($90,000) = $45,000
Now, to determine the daily HOOH allocable to a project, the formula is: (Allocable HOOH/Contract Performance Period) = Daily Allocable HOOH.
For our example, the calculation is: ($45,000/92 days) = $489 per day in allocable HOOH expenses.
Construction delay disputes
The Eichleay Formula can be most useful when navigating construction delay disputes. By knowing exactly how much each additional day on-site costs in HOOH, your company might be able to recover additional costs and preserve your profit margin on a project. Just be sure to use the actual contract performance period, not just the contract period, for the calculation to ensure you’re recovering as much as possible.
Learn more: 5 Ways to Reduce Construction Delay Disputes
5 tips to control overhead costs in construction
Hopefully, the calculations above show your company is standing in profitable territory. But, if determining your daily HOOH has your eyes bulging, or you simply need to cut some costs, the following tips for controlling construction overhead costs might help.
Go digital with construction management software
Time is money, and the old way of managing accounts payable, accounts receivables, billings, compliances, and even drawings is killing your bottom line. While there are always upfront costs involved in automating construction management, the amount of time construction management software can save your personnel can translate to real dollars in overhead cost savings.
Learn more about accounts with The Ultimate Guide to Construction Accounting.
Improve your bidding process
If you’ve been flying half-blind by not knowing exactly how much your indirect costs are, well, costing you, this is an excellent opportunity for growth. Every time you submit a bid, you can add labor, materials, and other direct costs, as well as a set value for indirect costs that will be allocable to that project.
Truly, this one value can be a serious game-changer.
Shop around
This might seem obvious, but shopping around for the best deals on materials, office supplies, insurances, and other regular costs can reduce overhead tremendously. Also, don’t forget interest rates.
For example, materials financing might appear to be more about cash flow than overhead, but if you consider interest rates, that couldn’t be further from the truth. Interest rates on credit cards are often considerably higher than those offered by materials financing companies. Shopping around for a low-cost materials financing partner can slash overhead costs tremendously.
Create effective accounts receivable policies
An accounts receivable policy is critical to the direction of a business, but when we’re talking about overhead, it becomes even more important. Having a policy in place that allows your business to collect the money owed to it faster can reduce interest payments and help make more efficient decisions.
There are questions to ask when developing your policy:
- Will you send preliminary notices on every project?
- Who is creditworthy? How much risk are you willing to take?
- How long will you wait until sending payment reminders? What about a notice of intent to lien?
- Will you use a collection agency for past due amounts?
- Does your policy protect your mechanics lien rights in the event that you need to file to recover your payment?
Having these policies in place will improve cash flow, reduce unnecessary interest, allow you to take advantage of bulk materials pricing, and implement systems to streamline every aspect of your business. Now that will take a chunk out of your overhead.
Don’t forget about accounts payable
We’ve touched on it a few times above, but allowing your accounts payable process to play second fiddle accounts receivable is also a mistake. If you’re not streamlining how you receive pay apps, how you pay them, and how you handle your vendors and materials suppliers, you’re bound to accumulate more overhead than necessary.
Automation is the most critical aspect here, as allowing subs and suppliers to submit pay apps online will undoubtedly speed up AP processing. It will also help you avoid late fees or interest. But, you should also consider early payments.
Savvy subs and suppliers know that they need to account for overhead in their bids. If they submit a pay app, don’t be afraid to contact them to see if there is a discount for early payment. An early payment allows them to pay less in interest, lessening their overhead while also reducing yours. It’s a win/win situation. And, since you’re protecting your cash flow, you’ll have the money on hand to take advantage of it.
Overhead truly is the cost of doing business
Overhead is unavoidable, but knowing how it works, how to account for it, and how to control it makes for a better business. A solid grasp on how much it costs you to do business allows company owners to streamline their businesses with automation, protect their payments with accounts payable processes, and submit accurate bids for the most profitable projects possible. Control your overhead costs today.