The Price is Right – Effectively Recovering Overhead When Pricing Contracts
Accurate contract pricing is absolutely critical if a contractor is to maintain profitability. Effective pricing can almost always be directly linked to the contractor’s ability to identify all costs of a contract that are expected to be incurred. Identifying and allocating direct costs, such as labor and materials, to individual contracts is a straightforward process. The same cannot always be said of indirect contract costs, or overhead.
Before a contractor can begin to evaluate the different methods of allocating overhead costs, it must first identify which costs should be included in the overhead cost pool. Indirect costs allocable to contracts typically include the costs of indirect labor, contract supervision, tools and equipment, supplies, quality control and inspection, insurance, repairs and maintenance, depreciation and amortization, and, in some circumstances, support costs such as central preparation and processing of payrolls. An easy way to identify whether or not a cost is an indirect job cost is to ask yourself the question, “If there were no jobs in process, would we still incur this cost?” If the answer is no, then the cost is likely an indirect cost and should be included in the overhead cost pool.
There are four commonly used methods used to allocate overhead: Overhead as a percent of total direct cost (the most common method); overhead as a percent of direct labor cost; overhead as a percent of direct labor hours; or a dual overhead rate recover method, in which two rates are applied simultaneously. The use of a dual overhead rate often produces more accurate overhead figures than an across-the-board application of a single method.
If a contractor’s overhead recovery is based on percent of direct cost, there is an assumption that the overhead associated with management of labor is equal to the overhead needed to manage the procurement and delivery of materials and subcontracts. This assumption is rarely, if ever, true. Contractors who use this method tend to over-recover (price too high) work that consists of a high percentage of materials and subcontracts and under-recover (price too low) work that consists of a high percentage of labor.
The second common method used to recover overhead is based only on the historical percent of direct labor costs. This method also incorporates an assumption that overhead is only created by labor management and that overhead created by the management of material and subcontractor procurement is minimal or non-existent. The result of using this method in a competitive marketplace is that a contractor will tend to over-recover work that is high in labor content and under-recover work that is high in materials and subcontractor content.
The third method of overhead recovery is based on direct labor hours used in a job. If a firm uses this method and has various wage rates, it can end up charging more overhead to one job that had a higher average wage rate than a second job with a lower average wage rate, even if the total time necessary to complete each job was equal. This method of overhead recovery also has the same flaw as the direct labor cost method: It makes the assumption that overhead is only rated by labor management and that the overhead created by the management of material and subcontractor procurement is minimal or non-existent.
The dual overhead rate recovery method addresses the flaws inherent in the methods discussed so far. By creating and assigning separate overhead recovery rates to labor and materials/subcontracts, you can see the differences in overhead created by the two types of direct costs. On any given job with any level of labor or material/subcontracts percentage of direct cost, we recover overhead at the rate it is created by these direct-cost multiplier components.
The best way to determine dual rates is to use a comprehensive 12-month budget tied into the fiscal year. The use of 12 months of data eliminates seasonal influences on the cost relationships. If the computation is not possible using a 12-month budget, a 12-month current statement may be used. However, be aware that when this is done the company is being guided by historical information, rather than more relevant information that may be available within the budgeted data.
Once you determine your budgeted materials, labor and overhead costs, you can determine your dual overhead rates on the following formulas:
Rate on materials and subcontracts =
overhead / ((X) labor) + materials and subcontract
Rate on labor =
(X) overhead / ((X) labor) + materials and subcontracts
Where (X) equals an overhead factor obtained from a study of how overhead fluctuates as the relationship of materials and subcontracts to labor changes. A leading construction industry consulting firm has developed a table of (X) rates based on a study of overhead, materials and subcontracts and labor fluctuations that can be used as a general guide. All firms should determine their own (X) factor rate table, a sample is as follows:
Materials & Subcontracts/Labor
|Labor Ratio||X Factor|
This method allows you to determine the breakeven cost and then decide how much profit to place on that job, based on the firm’s financial goals or on competitive market forces. If you choose to bid a job close to its breakeven cost, you can do so with confidence and clearly understand the profit implications when the firm prices the job–not six months after completion when your managers look at each other and wonder what they were thinking when they originally bid the work.
For more information please contact Audit Partner, Kenneth Gardiner, CPA, CCIFP, CDA at (315) 472-9127 or email@example.com. Ken is an Audit Partner with over 30 years of experience overseeing audit and accounting services to the construction industry. He was the first person in upstate New York to be given the designation CCIFP (Certified Construction Industry Financial Professional.)