Revisiting your indirect cost allocation methods

Whether most your work comes from a governmental entity on a cost plus basis or you live your life one estimate at a time, establishing and allocating your indirect costs is imperative to generating timely and useful job cost reports and ultimately year-end financial statements.

These reports are necessary internally for budgeting and future estimating but also externally for banking and bonding purposes. For perspective, consider how your bonding agent reacts when they see significant swings in overhead costs consistent with the fluctuations in the amount of work being performed.

To help reduce these swings in overhead costs and ensure that job activity reflects all true costs of performing the work, the below steps can be used to establish an allocation method appropriate for the type of work you perform.

Knowing your software

Starting off, it’s important to know the capabilities of your software. Depending on the nature of your company, it may work to have a single allocation methodology. In other instances, multiple layers may be necessary. Understanding how your job cost tracking system works with your payroll system and how that all flows into your ERP is necessary to determine how specific you can get in your allocation methods.

Knowing your business

The first step to allocating indirect costs is understanding how they are generated. A few examples of indirect cost drivers are:

• Direct labor hours
• Direct labor dollars
• Equipment hours
• Equipment dollars
• Total direct costs

Take some time to review your indirect costs and assess what is the core driver for any increase/decrease to those costs. For heavy highway contractors, the use of equipment hours might be the best methodology to track indirect depreciation, insurance and maintenance costs. For mechanical contractors with a service division, having multiple methodologies allocated by labor hours and/or dollars may be appropriate.

Knowing how much to allocate

This step can be the most difficult to set up, but once a good process is established, any changes can be easily implemented. When developing an understanding of how much to allocate, consider the following:

• How much project manager time is truly administrative rather than directly tied to specific jobs?
• How much of shop costs (including depreciation) can be allocated to supporting continuing job productivity?
• What portion of office depreciation, rent and utilities can be allocated to jobs? This is something that can be easily allocated consistent with the project manager’s cost.
• What labor burden costs can be allocated to jobs? Specifically, consider PTO, sick time, benefit plan contributions and expected bonuses for employees, in addition to the core insurance type costs.
• What depreciation and other vehicle costs can be directly allocated to a job?

When considering the above examples and looking at your own business, ask yourself which costs would only happen because there is work to be done and which costs would be necessary regardless of how busy you are. Those costs that would only exist because of outstanding projects should be part of your allocation consideration.

Calculating your indirect cost or burden rate

When considering the above factors and cost drivers, the next step is to calculate your indirect rate and allocate based on a consistent methodology. This rate should be reviewed on a regular basis, as factors that may have a significant impact on earlier estimations can change. While the presentation of an over- or under-allocated indirect cost is acceptable, revisiting your rate on a consistent basis can help reduce the impact of unexpected swings.

In assessing potential impacts to your indirect rate, consider changes to labor projections during the year on your insurance rates, allocation of project manager time in a season of overly difficult projects, and unexpected changes to the overall work environment. Specifically, consider how COVID-19 has had an impact on your insurance rates, labor hour budgets and home office costs.

Putting it all together

With a strong understanding of what your indirect costs are and how to best allocate them, the next step is to ensure that your jobs reflect these new costs. This needs to occur at all stages of the job between estimating, job performance and close-out.

Budgeting indirect costs from the onset is necessary to maintain consistent expectations for job progress through completion. Quite often, indirect costs are allocated as part of a year-end accounting adjustment, which can call into question the validity of earlier projections and interim job progress reports. To avoid any confusion as to what happened in a given job, explain any changes in your allocation methodology up front so they know what to expect.

Federal Acquisition Regulations

No article on indirect cost allocation would be complete without discussing everyone’s favorite Federal Acquisition Regulations. We’re not going to dive too deep here. It’s just important to note that, while the information in this article is applicable to all contractors, there is an additional level of complexity when entering into contracts subject to the Federal Acquisition Regulations.

Ready to change your indirect cost allocation methods?

Having an accurate and easy-to-update method of allocating indirect costs can be very complicated the first time through. In addition to potential issues above, it can be difficult to get others in your organization to accept changes to methodologies that have been in place for years. Also, looking at what allocating costs can do to “known” job margins can result in a little sticker shock.

In spite of these potential issues, having a better understanding of what your jobs truly cost will allow for stronger cash flow projections, individual job estimations and more consistent financial statement reporting.

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