How to Allocate Overhead to Projects

The Common Method Is Almost Always Wrong

The most common mistake is allocating overhead as a percentage of job cost. This practice is so universal that we rarely meet a contractor who veers from it.

For example, assume a painting contractor has $1 million in annual sales, $750,000 in direct costs and $150,000 of overhead. He would mark up every estimate by at least 20 percent to offset his overhead costs (150/750).

It's easy to see why this method is so popular. It is simple to apply. It is promoted by virtually all CPAs and business consultants. It is also a greatly flawed approach that only works properly in certain situations.

The problem with allocating overhead per dollar of direct cost is that most overhead costs are not driven by dollar volume. They typically are driven by several other things.

One qualifier needs to be stated here. If you are thoroughly charging all direct costs to each job as a direct cost, then the only remaining overhead would be completely independent of the work. That small remaining overhead expense can be allocated by direct cost dollar. However, it can also be charged out per man-hour which is my preferred and recommended approach.

Competitive Advantage

You might be wondering why figuring out how to allocate your overhead properly is worth the time and trouble.

The problem with misallocating overhead costs is that you end up over-estimating the cost of some jobs and under-estimating the costs of others. In other words, you end up winning jobs you don't want (headache jobs) and losing jobs you do want (easily managed jobs).

Even better, since almost all contractors allocate their overhead improperly, you can use that to your advantage by bypassing opportunities that would place excessive time demands on your overhead staff and instead concentrating on opportunities that are very overhead efficient. You aggressively pursue the good jobs and bypass the bad ones.

Misallocated Direct Costs

As mentioned above, one of the contributors to misallocated overhead costs is the burying of job related expenses in the administrative overhead area of your income statement. Accounting packages almost force you to do this. Their default setups encourage you to treat liability insurance, workers compensation insurance and payroll taxes as overhead items despite the fact they are directly related to the hours your field workers put in.

Most accounting systems get set up with field labor payroll, material expense and subcontractor expense as the only cost-of-goods-sold or direct cost expenses. Equipment and almost everything else gets assigned to the overhead bucket. This practice is dangerous on several levels and should be avoided.

The simplest solution is to code these items as direct costs. One way to do that is to assign project numbers to each of the different categories. That will pull this information out of your overhead and reduce the amount of general overhead you need to distribute. You will have to allocate the direct/indirect overhead to each project. Again, the simplest approach is to do that by man-hour budgeted or used.

Equipment costs should almost always be charged out by job. The only situation where burying equipment cost in overhead will not be a problem is when every job uses the exact blend of equipment for the same amount of time. There are very few trades and business models where that condition would hold true. Your default assumption should be to cost your equipment to each job that uses it.

Demands on Office Staff

The second major allocation mistake is overlooking the time demands placed on the front office staff by different job types, sizes, complexities, etc. What drives the project
management time on a job? The dollar value of the job? The length of the job in days or weeks?

It is not uncommon to conclude that the management time required for a project didn't change significantly across the jobs. One job required as much attention as the next. In that case, you should determine a cost of project management per job and build that right into the estimate as a direct cost.

The same thing can apply to the estimating function. If all estimates take roughly the same length of time, figure out the number of projects you land annually and divide that
into your estimating costs (e.g. your estimator's salary and benefits). Once again, build that into each estimate as a direct cost.

Remove the Material Costs

Material costs have no bearing on overhead. If you insist on allocating your overhead per dollar of direct cost, at the very least remove the material cost and re-calculate the allocation ratio.

Commissions and Bonuses

We have now arrived at the issue that triggers the passionate discussions between Guy and me. How to determine exactly what commission rate to pay salesmen. I am not going into the details of how to do that as it has been written about before and is a very involved calculation with several possible angles depending on your exact situation.

Let's leave it as this: if you don't allocate your direct costs and overhead costs properly, your sales force will chase the wrong jobs. By allocating properly you strongly influence the work that your salesmen bring in.

With overhead allocation, the easy way hurts your bottom line and makes your day-to-day life more stressful than it needs to be. Take the time to figure out how to properly allocate your expenses.