Are You Losing Control of Your Indirect Costs?

by: Smith and Howard

December 2, 2015

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It’s natural and understandable for contractors to focus on their projects. That’s what you’re supposed to do, right? Manage your jobs and the money that goes directly into them.

But underlying those “direct” costs are “indirect” costs — generally defined as expenses arising from activities associated with more than one project. Because these expenditures tend to be rather indistinct for construction companies, you need to keep a close eye on whether you’re losing control of them.

Mind the little things

Indirect costs aren’t the same as overhead. The latter term refers to the costs of running your overall business. Indirect costs, on the other hand, still relate to contract performance — just on a wider scale than direct costs.

For instance, if you pay salaries for activities such as project management, purchasing, contract administration and safety oversight, these likely count as indirect costs. Any fees you incur for real estate appraisals, consulting services and legal and accounting needs also likely fall in this category. And, of course, don’t forget taxes, title transfers, general permits, direct costs and some types of insurance.

Costs such as these can have a huge impact on jobs. If you neglect to figure them in completely, or at all, surprising cost overruns and profit margin fluctuations may result.

Track your tax liability

How indirect costs are treated for tax purposes depends on the nature of a contract and your accounting method. This is one of the prime reasons you need an accurate and trustworthy system for allocating these amounts.

For example, under the federal tax code, contractors must allocate indirect job costs to their long-term contracts every year. If you use the percentage-of-completion accounting method, you may be able to deduct some allocable indirect costs such as equipment depreciation and workers’ compensation insurance. But if you use the completed-contract method, such expenses must be capitalized over the contract’s term until completion. (Ask your CPA for further details.)

There’s no one-size-fits-all approach to tracking and allocating indirect costs. If you’ve been in business awhile, your established method may serve you well. But it doesn’t hurt to review it periodically to see whether anything is slipping through the cracks and causing you to suffer tax or accounting headaches.

Know where you stand

Of course, beyond taxes there lies another question: Are your indirect costs simply too high? You need to know precisely how much indirect costs are affecting you financially, so you can make realistic yet competitive bids.

One way to get a good read on this question is to sit down with your CPA and go over your chart of accounts. It should contain an adequate number of categories to let you see just where your expenses lie.

Plus, your chart of accounts can enable you to set up a budget-to-actual analysis that compares budgeted annual amounts of various expenses with actual costs (both indirect and direct) incurred. The right accounting software can greatly facilitate this exercise.

Another approach is benchmarking. This is a process under which you pick certain metrics — say, a selection of typical indirect costs — and measure them against those of similar construction companies. Trade organizations perform annual surveys that can provide the data you need, or you may be able to engage a construction business consultant to gather the information for you.

Whether it be from an analysis of your chart of accounts or a benchmarking study (or both), when you have the data you need, look to start cutting. Rare is the construction company whose indirect costs are at minimum levels. So define which indirect costs are fixed and which are variable. The latter may be easier to trim.

Crunch the numbers

Indirect costs often get lost in the middle between the many specific, direct costs of a construction company’s projects and its widespread general business expenses. Be sure you’re regularly crunching the numbers on your indirect costs or you might find yourself suddenly noticing them for all the wrong reasons.

If you are looking for construction tax, accounting and advisory services to help grow your construction business, contact David Lee at 404-874-6244 and/or simply fill out our form below.

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