Accurate costing systems are vital in construction. As an industry deeply rooted in competitive bidding, contractors often win work by coming in with the lowest bid. The challenge, of course, is to make sure your projects are neither underpriced (leading to financial losses) nor overpriced (leading to loss of business).
To build a sustainable business, contractors need costing systems that accurately account for direct costs as well as overhead. When you get a better handle on everything that goes into a job, you can put a better margin on your project — and avoid losses on either side of the equation.
Below we cover how standard costing can help you improve your profit.
Standard costing for contractors
Standard costing is an accounting practice that helps an organization spot the variances between expected costs and actual costs. By highlighting those variances, construction managers can see red flags and opportunity areas.
Standard costs are what you expect a job will cost. When you’re estimating a project, you have expected costs for material, labor and subcontracts. We call these your direct costs.
You should also have expected operating costs, such as those related to the shop and yard, vehicle and equipment expenses and employee benefits. These are your indirect costs.
In the construction industry, actual costs are rarely an exact match for the standard cost. The differences between the two are known as variances.
Knowing your variances is useful for estimating and general management. The sooner you spot a variance, the better you can respond and adjust.
Estimating your indirect costs
Direct costs are those that can be specifically linked or traced to the project. Indirect costs can be trickier to nail down. They represent the consumption of company resources that are shared across all work projects. These are costs that are necessary for your operating activity but are not directly traceable to a department, project, activity, customer, etc.
Note that indirect costs are different than overhead expenses. Indirect costs do not include selling and general administration costs that are not directly incurred to complete your jobs. Overhead costs like rent, office wages and advertising are fixed and predictable.
Indirect costs, like workers compensation, equipment maintenance, safety training, etc. can be variable depending on how much work you do. So what you want to do is come up with a standard cost for your indirect costs.
One way to do this is to estimate your total indirect costs for the year and divide this by your estimated labor hours. Let’s say you expect to have $1 million in indirect costs and 50,000 labor hours. That gives you a standard indirect cost of $20/hour. So for every labor hour that you incur, you’re going to apply $20 to that job.
$1,000,000 estimated indirect costs/year
÷ 50,000 estimated labor hours/year
$20 standard indirect cost/hour
If calculating costs per labor hour isn’t right for your business, choose the driver that most closely aligns with your business model. Most construction companies use inputs such as labor or equipment hours, but some will use outputs such as quantities of material provided.
Coming up with your standard indirect cost is an iterative process. The more data you have about your business operations, and the more you analyze your variances, the better handle you will get on indirect costs.
Admittedly, it’s difficult to forecast your labor hours (or other driver) for the year, and this will result in under/over allocating your indirect costs. Evaluate jobs periodically to determine if any outlier jobs should have more/less indirect costs applied. Then, reconsider the rate to be allocated going forward to reduce under/over allocation.
Construction project reviews: variance analysis
With standard costing, you can keep an eye on the actual cost of your projects. Since you’re billing for projects based on your estimated price, accurate estimates are incredibly important to your construction company’s performance.
Get in the habit of doing regular project reviews. Weekly or monthly reviews are ideal and should include project managers, the general manager/owner and your accountant.
The sooner you spot a variance, the sooner you can give it your attention. In some cases, you might find opportunities for additional revenue. Or, you might gain awareness and insight about challenges occurring on the project.
Project reviews can also be a trigger for customer communication. At each review point, you’ll have valuable information about project status, timing, possible delays and opportunities. You might, for example, discover affordable expansions or upgrades that could be presented to the client as an option while the job is in progress.
You know that poor client communication is a quick way to find yourself sideways on a job. But sometimes contractors are hesitant to communicate because they don’t have anything meaningful to report. Regular project reviews are a way to ensure you know where the job is at and have a useful update for the client.
In addition to project reviews, conduct a monthly review of your work-in-progress schedule (open and closed) and how it relates to the financial statement. Look at the following:
- Gross profit percentage — closed vs. open
- Hindsight analysis by job type, project manager, customer, etc.
- How good are your estimating skills?
- Jobs that are in a loss position
- Jobs that have significant swings in gross profit
The monthly work-in-progress review is a rollup of the project reviews you’ve already completed and will provide more information you need to manage operations, create better estimates and bid on the projects that best match your company’s sweet spot.
How Wipfli can help
Solid accounting practices are essential to keep your business profitable for the long-term. Professional assistance from Wipfli can help you make the most of your construction business. We can help you get a handle on job costing and margins. Contact us to improve your construction accounting practices and grow your profit.
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The three “D”s of fixed asset accounting: Dos, don’ts, and details