Overhead allocation is a source of great disagreement in our industry. Should the allocation be based on job price? On job cost? Per project? Or per field man-hour. We understand the pros and cons of each of the sides. The method that works best for trade contractors may not work well for service contractors or general contractors. As a matter of fact it usually doesn't.
I am on record as strongly advising trade contractors to allocate their overhead costs based on field man-hours.
One thing you must remember is that all of your estimating, budgeting, scheduling, job costing and financial reporting systems need to adhere to the same basis of allocation. If you forget how you're defining the hours you will end up either double counting or worse, overlooking cost.
A quick review
Trade contractors are in the business of selling field man-hours. You were aware of that right?
Your entire business revolves around getting work for field crews, getting the field crews to perform the work within budget and getting paid for the work.
Your front office should be staffed to support the amount of work your field crews perform. Your equipment fleet should be sized to support the amount of work your field crews perform. Your yard and shop should be sized to support the amount of work your field crews perform. When one or more of those items gets out of alignment with the amount of work your field crews perform you lose money.
Overhead's purpose is to support those items. If overhead is sized to support the field crews doesn't it make sense to charge overhead based on man-hours? A simple real-world example will demonstrate the fallacy of allocating overhead based on job cost or job price.
Several years ago I was going over the income statements of a paving contractor. I noticed that his revenue jumped 20 percent from one year to the next; however, his labor costs remained the same as did his overhead costs. His gross and net margins had shrunk. Digging a little deeper revealed the answer. The extra 20 percent in revenue was driven by a steep increase in asphalt material and subcontractor cost.
The job cost reports were extremely misleading as they were allocating overhead based on job price. Adding up all the allocated overhead from the job cost reports produced an allocation that was 20 percent higher than the final overhead expense. If the overhead had been allocated by man-hour the numbers would have matched up almost perfectly. The business had performed equally well both years. There was no real growth.