Indirect Job Costs: Performing Accurate Project Cost Analysis
By Andy Choi, Senior Manager, Assurance Services
Accurate budget forecasts are crucial to guaranteeing long-term success for construction companies of all sizes. Without a well-established budget, construction projects can fail and lead to cash shortages.
For example, a company could win a bid for a project that is over $100 million and end up losing $2 million at completion, or win a bid for a project under $20 million and make $2 million in profit.
Among the many possible reasons a project might not generate the anticipated profit is failure to account for all project costs in the estimation stage. With pricing contracts, it is easy to account for tangible project costs such as subcontractor invoices, material purchases, or labor hours. However, costs that are less apparent, known as indirect costs, are often overlooked during the estimation process.
For construction contractors, the key to analyzing and correctly projecting profitability is to examine every contract as a profit/cost center. Only then can a company begin to understand its true performance on a specific project. By comparing actual costs as they are incurred to the original estimate, a contractor gains a more accurate understanding of individual job performance, which will lead to success.
Direct job costs
Direct job costs are directly attributable to a project and include materials, labor, equipment, and subcontractor costs. These costs are easy to identify and apply to a specific project. Pricing a job based solely on direct costs, without factoring in indirect costs, leads to underestimating the total project delivery cost and thus reduces the contractor’s profit. Underestimating costs when bidding a job can and often does result in a loss on the contract.
Indirect job costs
Many contractors confuse indirect costs with overhead (general and administrative expenses), but they are not the same. Overhead is the cost to run the company, but it is not necessarily associated with performance on a specific project. A company incurs general administrative expenses regardless of whether it has any projects.
Indirect job costs are those necessary for the delivery of a project. If indirect costs are included in overhead rather than allocated to a project, they can they can artificially inflate G&A expenses while creating underbillings on the contract. This also distorts project analysis and masks the true profitability (loss) on a project.
Some examples of indirect costs are:
- Depreciation expense
- Tools & equipment
- Labor benefits (vacation time, sick leave, etc.)
- Repairs & maintenance
Identifying and Allocating Indirect Costs
Tracking construction project costs can be time consuming, as some costs are difficult to identify. This is especially true of indirect costs for a specific contract. However, without knowing these costs, a contractor cannot make an accurate project estimate that earns a profit. Contractors must know precisely how indirect costs affect them financially so they can make realistic, competitive bids. They must also examine all costs thoroughly to determine which are specific to individual jobs and which apply to the company as a whole. It is important to have a clear understanding of which cost components drive jobs.
Contractors should also evaluate how indirect costs relate to a project and how they fluctuate compared to direct costs. Evaluating how indirect costs are incurred is the most important component of allocating costs to a project. For instance, if construction equipment repairs and maintenance are necessary for every 100 hours of use, these costs should be allocated for each hour a piece of equipment is used for a specific job to account for this cost. In addition, indirect labor costs such as vacation and sick leave should be allocated by each labor hour. Indirect cost allocation should be based on how the indirect costs occur. More importantly, these allocated costs should be applied in a consistent manner across all projects. Allocations should be consistent regardless of contract types, including time-and-material and cost-plus contracts. The process does not stop here. Contractors should periodically perform budget variance analyses to compare actual costs to estimates to determine whether their indirect cost allocations are accurate and whether they are over- or under- allocating.
Indirect costs are often overlooked and can become unnecessary surprises if not accounted for properly. The construction industry is risky, and project cost analysis is the key to success. A contractor who does not know a project’s true cost will likely bid the job at a lower profit or even a loss. Now is the time to evaluate whether or not project costs are being captured correctly so that hard-earned profits can be maximized.