Chapter 2: Expenses
Before we make things complicated, let's focus on our simple goal:
We work to make money.
In order to make money, we have to bring in more than we spend. This is the whole purpose of job costing. It helps us track our expenses so they don't get out of hand, thus ensuring we have a profit.
Estimating Job Costs
Before starting a project you must get an accurate estimate of all your costs. Estimating is a critical step that will lay the foundation for a profitable job.
An estimator can use market data and historical accounting data to predict how long a project will take, how much material will be needed, and what it's going to cost. A job cost estimate will include:
- Labor - This is more than just a total number of hours. This will be a specific breakdown of the type of labor being done, because workers are paid different rates for different tasks.
- Materials - Construction requires a lot of materials, so this part is critical. Also, surprises always come up and some work will need to be redone. It's important to build in a little buffer for extra materials that might you might need—like extra paint.
- Equipment - Some equipment may need to be rented, so rental expenses will be based on estimated time to complete the job. For equipment that's already owned by the company, you will still need to track the amount of hours the equipment is used. This time is used to estimate the item's depreciation. Also, a lot of equipment requires gasoline, so that will need to be estimated and tracked.
- Subcontractors - A general contractor may subcontract out parts of a job to a specialist. You will need to be familiar with the subcontractor's rates and fees to get an accurate estimate.
These are considered direct costs, because they're directly related to completing the work. However, in addition to the obvious expenses, other costs must be considered. There are also overhead costs, including office rent, office staff, utilities, insurance, company car maintenance, advertising, etc. Overhead is considered an indirect cost, because although it's needed to keep the company running, it's not directly related to the job at hand.
Overhead
If you have job expenses of $150, and you are paid $200, it may appear that you made a $50 profit. However, this math doesn't consider your overhead expenses. When you add those in, you may not have any profit left.
In order to make sure all your expenses are covered, you need to pay for your indirect costs throughout the year. These costs should be divided up and added to your direct costs on each project. Each job will help pay for a portion of the overhead.
How do you know how much overhead to include on each job? If you have indirect costs of $80,000 each year and you estimate you'll have 8 jobs, it would be easy to just break that up into even parts—$10,000 of overhead added onto each job. Unfortunately, although the math is nice for us, it's not necessarily nice for the client. $10,000 dollars of overhead costs for an office building construction might make sense, but that would be absurd for a sprinkler repair.
We need a method of allocating our indirect costs that takes into account the size of each job. We do this by calculating an overhead rate. This rate can then be added to a job based on how much work needs to be done. The bigger the job, the more overhead it covers for the construction company.
Calculating Overhead Rate
An overhead rate is the amount of money spent on overhead for every dollar spent on direct costs. If your rate is $1.25 or 125%, that means your company spends $1.25 in overhead for every $1 you spend on direct job costs. This rate helps you determine how much overhead to apply to each job.
In the construction industry, companies often have an overhead rate of 10-20%.
To get the overhead rate, first you need to estimate your total overhead for the entire year. For expenses like rent, that should be predictable. For expenses like utilities, you'll just have to make your best estimate based on past utility bills.
Once you have your total estimated overhead, you need to divide it up among the jobs you'll have that year. Start by looking at past years and estimating how much work you expect to get. Next, choose a measure of activity from those jobs—like labor hours or direct costs—and estimate that amount for the upcoming year.
There are a several measures of activity you can use. Each gives you a slightly different method for allocating indirect costs throughout the year. Here are a few common ones:
- Labor Hours - Total Overhead / Total Labor Expenses = Overhead Rate. Ex: Overhead of $25,000 / Labor Costs of $50,000 = $0.50 or 50%
- Direct Costs - Total Overhead / Labor Costs + Material Costs = Overhead Rate; If a contractor does work that is very heavy on material costs, like solar panels, this method might be a good fit.
- Machine Hours - Total Overhead / Machine Hours = Overhead Rate. This method would make sense for an insulation contractor that is primarily using a machine to blow insulation into a home. Machine usage would be a good indicator of job size in this case, but not for companies that mainly work manually.
Now that you have an overhead rate, what do you do with it? When you are estimating costs for a job, you multiply those costs by the overhead rate. Example: You will be spending $3,000 on materials for a roof repair. You have an overhead rate of $0.20. You would need to multiply $3,000 by 0.20 to get $600. That $600 is the amount of overhead that you can add to your costs for that job.
Overhead rate doesn't have to be calculated for an entire year. It can also be calculated monthly or quarterly. If a company is experiencing big changes, like rapid growth, it may be wise to reassess overhead multiple times throughout the year.
Cost Codes
There are many parts to a construction job. There are multiple phases, types of expenses, types of material, and types of labor. Each of these items is unique, so they need to be assigned a unique ID number, or cost code.
Cost codes help organize all your expenses into easy to find categories. For example, if a plumber is installing toilets into a commercial building, that would be code cost 222400. An estimator would use that code when estimating costs for that part of the job. During the job, actual expenses pertaining to that item would be recorded using the same cost code. This makes it easier to compare estimated costs to actual costs.
Cost codes are the secret sauce of job cost accounting because they allow you to run reports on a very detailed level.
Don't Forget the Profit
Now that you have a detailed estimate of your job costs—including overhead—you can prepare to bid on a job.
When you bid on a construction project, you need to accomplish three things: 1) Cover your direct expenses, 2) Cover a portion of your indirect expenses, and 3) Get profit.
We've already covered direct and indirect expenses, so now we need to calculate our profit. Each industry has a standard profit margin that they charge. The construction industry typically runs between 10% to 20%.
This margin is calculated as a percentage of the expenses required to complete the job. If you're building a dog house that will cost you $150 in materials and $300 in labor, you'd have $450 in total expenses. Now you can calculate a profit margin of 10%, or $45, and add that into your bid for the job.