Unallocated Job Costs
Chances are your construction company is underestimating the cost on each specific job. The process of obtaining bids and estimating project costs is straight forward when it comes to direct expenses such as subcontractors, direct materials, and direct labor. Those direct costs provide a guide to profitability from job to job but don’t account for the overall cost of doing business. So, while a 10% gross profit margin per job seems obtainable, by year end when all Costs of Revenues are accounted for gross profit might be just 5%. That is because unallocated expenses incurred throughout the year are included in total Cost of Revenues but didn’t get included in the individual job estimates.
When reviewing company financials, it has been our experience that Cost of Revenues typically exceed the total costs reported by job by a significant amount. The source of this difference is indirect costs which include many basic expenses such as employee benefit pay (paid time off, holiday, and sick pay), tools and supplies, vehicle expenses, insurance, equipment repairs and maintenance, asset depreciation, and rent. All of these expenses relate to completing jobs but cannot be trace to any one particular project. The indirect nature of the costs presents an added complexity in cost allocation which is why such indirect costs are often unaccounted for in the job costing process.
Allocating indirect job costs to specific projects will provide managers and estimators with the real cost of each job and can lead to more accurate bids and assist in reaching profitability goals. There are different approaches to allocating indirect costs depending on the nature of work performed. A basic approach includes the following steps:
1) create cost pools of expenses
2) determine a rate for the cost pool
3) apply that rate to each job estimate and actual results
A cost pool might be equipment costs that aggregates such items as depreciation, fuel, insurance, and repairs which is commonly known as equipment burden.
Another common cost pool consists of labor costs including worker’s compensation insurance, benefit pay, and health care or other employee benefits which is referred to as labor burden.
Calculating an initial rate is inherently just an estimate and is usually based on prior year financial data. The rate should be evaluated periodically but at least annually during the budgeting process. To establish an equipment burden rate, divide total expected equipment costs by the total expected equipment hours across all jobs. For example, if the equipment cost pool for last year was $100,000 and the company expects to use all equipment a total of 10,000 hours in the coming year, the burden rate for the upcoming year is $10/hour for each equipment hour. If desired, you can even set up different burden rates for different kinds of equipment.
For the labor burden rate, divide total expected indirect labor costs by the total expected labor hours for the year. For example, if indirect labor costs were $100,000 in the prior year and the company has five employees who each work 2,000 hours per year for a total of 10,000 labor hours, the burden rate for the upcoming year is $10/hour for each labor hour.
The formula for a burden rate is flexible and the choice should be assessed by management for appropriateness. If direct material costs are the driver of most job costs in the business then perhaps the rate should be calculated based on that metric rather than equipment hours or labor hours. Thus, if direct material costs for all jobs in the prior year were $1,000,000 and total equipment and labor cost pools were $200,000 then for every dollar of direct material purchased $.20 would be allocated to the job to account for indirect costs.
Allocation of costs
Once the burden rate has been established, the contract bid should include cost estimates for how much of the cost pool will be used on that job. In accounting for the actual results, software programs may automatically apply the rate to the job against resources used such as labor hours or equipment hours. If not, a manual allocation may be necessary.
A job that is expected to use five hours of equipment will have $50 of indirect costs from the equipment cost pool added to its bid estimate. If in reality the job used the equipment for only four hours $40 of equipment burden will be allocated to the job.
At the end of the year, all indirect costs should be allocated to jobs. If costs remain unallocated then the burden rate was too low and if more costs were allocated than indirect expenses incurred, then the rate was too high. The job costing process is by nature based on estimates. The better the estimate the more predictable results your company is likely to experience. BA Harris can help your company improve its job costing estimates by evaluating what costs to include in cost pools, establishing burden rates, applying those rates to your actual results, and assisting in the decisions for the best technology tools to support your costing needs. Please contact us if you would like assistance with this process.
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