All of your estimating, budgeting, scheduling, job costing and financial reporting systems need to adhere to the same basis of allocation.
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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.
Which man-hours to base the allocation on?
Time to dive into the man-hour allocation details. As simple as allocating the overhead based on man-hours may sound it still leaves unanswered a few questions. Should the overhead be allocated based on budgeted man-hours? Should it be based on used man-hours? Should we factor in all field crew man-hours or just those charged to jobs? There really isn't a right answer.
My preference and the method I move my clients to is to allocate overhead based on actual man-hours used in the field. My preference is driven by the knowledge that the faster the crews finish work and the less time they spend on non-project related activities (e.g. working on the equipment) the more money you make. In simpler terms, the more work they get down per man-hour the more competitive your costs are and the more work you can sell.
Let's say you are set up to support roughly 50,000 production hours. Those 50,000 production hours may result in total W-2 payroll hours of 55,000. Your estimates are built around the 50,000 production hours. Believe or not, if you don't account for the missing 5,000 man-hours in your overhead you will end up under-estimating your total expenses for the year. This is a common cause of the ever present question "Where did my money go?" at the end of the year.
Continuing on, if your overhead staff is set up to support 50,000 production hours and your crews take more time than budgeted your income will be reduced. Your overhead didn't go down. Your field costs didn't go down. Just your income went down because your crews didn't finish all the work they were scheduled to get done - or you suffered considerable overtime charges.
If your crews work faster than budgeted, they will complete more projects for the same total labor cost and overhead cost. Sure your material and subcontractor expenses will be a little higher but your revenue jump will outrun their increase significantly.
My mantra to my clients is "We're selling man-hours. How many man-hours are we going to sell this year?"
My clients focus equally on man-hours sold and revenue sold. We keep a close eye on revenue per man-hour of our sales. We keep a really close eye on our consistency in completing the projects within the hours budgeted.
The job cost reports allocate the job's overhead costs based on the total man-hours used. Completing the job in less hours than budgeted not only reduces the direct labor costs but it reduces the allocated overhead costs. A double win. Of course, the opposite also holds true.
A word about your accounting system. Accounting systems are almost never designed or setup to allocate overhead to projects in their job cost reports as I am recommending. That's the reason why I couldn't care less about a job cost report produced by an accounting system. The job cost report I want to see is budgeted hours versus hours used. Budgeted material quantities versus quantities used. Budgeted subcontractor costs versus subcontractor costs suffered. Budgeted equipment costs versus equipment charges. If all of those numbers meet their budgets, your project met budget - no matter what your accounting system's job cost report tells you.
The choice is yours. You can allocate overhead the supposedly easiest way, based on job price, or you can allocated overhead based on the way that generates the best bottom line, per field man-hour.