Don't misinterpret indirect costs
when accounting for job contracts
The construction industry has long struggled with the inherent
challenge of accounting for indirect contract costs. Why?
Because when these expenses occur they often don't pertain
to only one contract or because foreseeing what their actual
amounts will be - such as with repairs and maintenance - may
be difficult. Let's examine how you can better account for
indirect costs to enhance your bottom line.
Make the distinction. The
American Institute of Certified Public Accountants (AICPA)
issued Statement of Position 81-1, "Accounting for performance
of construction-type and certain production-type contracts,"
to guide contractors on the indirect costs problem and others
In one paragraph, SOP 81-1 states, "Contract costs generally
include direct costs, such as materials, direct labor, and
subcontracts and indirect costs identifiable with or allocable
to the contracts." More specifically, indirect costs
- Contract supervision
- Tools, equipment and supplies
- Quality control and inspections
- Depreciation and amortization and
- Repairs and maintenance
Many contractors refer to these costs as "overhead,"
but this misnomer actually leads to a critical problem. That
is, overhead encompasses general and administrative expenses,
which include advertising, dues and subscriptions, office
supplies, salaries, legal and accounting fees, office rent
These costs are essential to your company's overall operation,
are relatively stable and typically don't fluctuate as a percentage
of work volume over time. Conversely, indirect costs are related
only to contract performance. Thus under SOP 81-1 you should
expense general and administrative costs as incurred and you
shouldn't include them as indirect costs when estimating job
Truth is, discrepancies frequently arise among contractors
when distinguishing between general and administrative expenses
and indirect job costs. The critical factor here is the work
"identifiable." Examine overhead costs thoroughly
and determine which ones you can identify to individual jobs
(indirect costs) and which you can attribute to your company
as a whole (general and administrative costs).
For example, you probably buy liability insurance via an
annual policy and not on a job-by-job basis. Although 100
percent of this cost doesn't pertain to one individual contract,
a portion of the total cost does and you should consider this
an indirect cost. But the exact amount of this percentage
will vary from contractor to contractor.
Allocate for best results.
After you've separated them from general and administrative
expenses, how do you allocate your jobs' indirect costs? SOP
81-1 says to use a systematic and rational approach, which
includes allocations based on direct labor hours (or costs)
and material costs.
The appropriateness of indirect-cost allocations, as well
as the methods for determining them, depends on the circumstances
and calls for your sound judgment based on a financial professional's
To get started, identify the casual relationships between
an expense and its driving force. For instance, repairs and
maintenance on equipment is most likely driven by the equipment-usage
time. So an appropriate allocation of repairs and maintenance
expense may be hours of owned equipment use on a particular
How might this work in practice? Well, indirect repair costs
are typically expenses on a construction company's books when
the cost is incurred. So when you use a piece of equipment
on a project, you could charge a predetermined hourly rate
(typically for each hour of equipment use) to the respective
This would account for repair expenses that occur over time
because of using the equipment and not charging these costs
within a project's scope. But, because this expense is just
an estimate to reflect an indirect cost within a job's gross
profit, the other side of this accounting entry would be to
a "contra-expense" account, thus having a zero income
Analyze job by job. Having
allocated your indirect costs to specific jobs, you must then
analyze profitability by job to determine whether you're maintaining
adequate profit margins. If you don't correctly factor indirect
costs into your job-profitability calculations, you'll likely
overstate job projects, and future bids won't adequately cover
In addition, reflecting indirect costs through job cost will
allow you to more accurately estimate revenues earned through
adjustments to costs in excess of billings and billings in
excess of costs. If this adjustment is incorrect, your revenue
will be incorrect - distorting the gross profit for the job
in question and your construction company as a whole.
Ultimately, underestimating indirect costs when bidding usually
leads to contract losses, while overestimating may prevent
you from obtaining new jobs in today's competitive market.
So an understanding of the relationship of indirect costs
to your individual jobs is key to ensuring profitability.
Stay alert always. Because
indirect costs will fluctuate over time, adjust estimating
factors accordingly. For proof of these fluctuations, just
look at the current state of the insurance and surety business.
With policy and bonding costs on the rise, and indirect-cost
estimating formulas becoming outdated so quickly, make sure
to revise and test your accounting methods periodically to
Editor's Note: Randy
J. Bonnecaze is a Certified Public Accountant (CPA) with Hannis
T. Bourgeois LLP, Baton Rouge.