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Identifying indirect costs in construction

Visual using iconography: dollar sign inside a circle | Identifying cost centers in construction | Knowify

Profit is the fuel that keeps everything running. Whether it’s a small mom & pop shop, or an international giant, no business can last long that doesn’t consistently turn a profit.

However, the actual term “profit” is often thrown around quite haphazardly in most business settings. If asked, most people would define profit as “making money.” As we’ll learn, however, profit is much more nuanced than this. Moreover, this causes many contractors to conflate profit and refer to it interchangeably with revenue and cash flow. However, there is a big difference between the three:

  • Revenue – The total amount of income generated from selling goods or services during a given period of time.
  • Profit – Total revenue less total expenses.
  • Cash Flow – The net change in a company’s cash position over a given period. Cash flow is often different from Profit due to timing issues (i.e., how quickly the customers pay and how quickly you pay your vendors) and the inclusion of non-cash items in the calculation of Profit (e.g., depreciation).

Revenue is all money earned by performing services and completing jobs. As you’ll notice, it has nothing to do with expenses. This is money that is exchanging hands from your customer’s wallet to your bank account for a job well done.

Profit, on the other hand, is defined as the difference between a company’s total revenue and its total costs over a specific period of time; it’s any money left over after covering all costs—“after covering costs” is the key phrase here. How a contractor defines costs and tracks costs is what makes all the difference.

One last note about Profit: you might think you’re profitable if you see your bank account balance going up each month, but this isn’t always the case so be careful!

There are many things that can cause cash flow and profitability to be different (and tell fundamentally different stories). Did you just start a few new jobs and take large deposits? Your business would be very cash-positive in such a period, but you don’t even know if those jobs will be profitable overall once they wrap up.

Good accounting and job costing are essential if you want to avoid overextending your business in times when cash seems plentiful.

Where does profit margin fit into all of this? While profit measures a specific dollar amount, profit margin is a percentage used to measure how much money a company actually keeps from every dollar of revenue it brings in.

Profit and profit margin are significant indicators of the overall success of a business. Owners can receive profits as payment or reinvest them back into the business to grow and scale operations.

Understanding profitability and profit margins helps contractors better assess the performance of their projects and make more informed decisions regarding pricing and prioritizing work.

Every business owner will claim to have the determination and focus required to become successful. You wouldn’t have taken on the risk of starting your own business if you didn’t. Time and time again, we have seen the hard work of contractors pay off in extraordinary ways.

Why then, do 66% of all contracting businesses fail within ten years? This is an impossible question to fully answer, but unequivocally, one of the leading causes is the inability to identify and account for indirect costs that drain profits without the business owner even knowing that it’s happening.

What are indirect costs in construction? How do indirect costs impact profitability? What are the hidden expenses that are costing my business money? We’ll answer these questions and more.

What are indirect costs?

Indirect Cost

Indirect costs are costs that affect the whole company, such as accounting services, insurance, depreciation, and overhead costs. They are not spent on only one job or project.

Think of someone who decides to purchase a new car. They find a car they like, check the price and save up just enough money to buy the car they want. Then, with the paperwork signed, they drive off the lot knowing the exact price they just paid; but what they might not have factored into their decision is the cost of taxes, insurance, registration fees, or service plans.

These additional costs are unavoidable. New car owners quickly realize that the actual cost of buying a car is much more than just the sticker price.

While this is a lesson many first-time car owners learn, failure to account for indirect costs is also a common pitfall amongst first-time business owners. If not handled properly, these costs can drain profits. 

Indirect costs in construction can be straightforward, such as the cost of employing a single accountant; the accountant does not directly contribute to the profitability of jobs, as they are not physically in the field swinging a hammer. They do, however, provide invaluable financial services that can drive improved financial performance.

In construction, like many industries, time is money. It’s fair to think of any inefficient process, like manual data entry, as an indirect cost. It’s taking you away from revenue-generating work, preventing you from taking on new projects, or cutting into the profitability of your current ones.

With that said, indirect costs in construction are not always bad.

Most of the time, they’re essential to keeping your business operating smoothly. Identifying, observing, and tracking indirect costs is integral for contractors to understand their financial standing and maintain profitability.

Indirect costs in construction

To better understand cost centers in construction, let’s start with an example. 

Take, for instance, a roofing contractor that works as the sole proprietor of their business. They bid on jobs, do the work, and bill for their services all by themselves—working as a one-person show. As this contractor starts to get more and more work, however, they find the need to scale their operations.

To do so, they bring on two additional laborers to help on larger jobs, hire an accountant to help with finances and rent out facilities for performing administrative tasks and storing equipment. Of course, this means you must pay salaries and rent to keep operations running smoothly.

The accountant and new facility represent indirect costs since they incur a cost but don’t contribute revenue to the business. While this example provides a high-level overview, as we will see, cost centers become much more nuanced as we look at individual jobs and certain scenarios that are unique to the construction industry.

When it comes to job costing, you should allocate some, but not all, indirect costs to jobs. To understand why it’s not appropriate to allocate all of your indirect costs to your jobs, consider this example: would you need to hire more accountants if you grew your crews to take on more work? In many cases, the answer is no: your accountant could probably continue to support your business if you grew, say, 30%.

But should you expect to spend more on health, liability, and workman’s comp insurance if your business grew by 30%? Almost certainly yes. You should allocate any indirect costs that scale directly with your jobs to those jobs. This includes project management costs and insurance to name just a few. Conversely, you shouldn’t allocate any indirect costs in construction that don’t scale such as accounting or office rent.

From a business management perspective, you need to understand job-level profitability so that you can understand how many jobs you need to support your G&A infrastructure and to deliver the overall business-level profitability you’re targeting.  

Next, let’s examine some of the major indirect costs in construction and how we at Knowify feel you should treat them for job costing purposes.

Indirect labor costs

Indirect labor costs, meaning the cost associated with employing your people beyond their wage, can be substantial in the construction industry. These costs include payroll taxes, health benefits, and workman’s compensation insurance, among others.

We strongly encourange you to try to capture these costs in your job costing. Failure to do so can result in job profitability that are off by as much as 50%. Luckily, proper ‘burdening’ of your labor costs is just a matter of knowing where to access the needed information. Once factored into your financial assessments, the labor burden will help contractors accurately cost jobs and assess the true profitability of each job.

Labor burden in construction typically includes the following:

  • FICA (payroll taxes)
  • State unemployment tax
  • Health/Dental/Vision or other benefits
  • Retirement contribution
  • Workers’ comp

To access most of this information, contractors can reference payroll reports, workers comp documents, and health insurance papers. Once you identify labor burden, you must be aware of the various factors that affect labor burden.

These factors include:

  • Type of labor performed
  • Benefits offered
  • Location

For a more in-depth breakdown of labor burden and how it fits into a well-rounded job costing system, reference our essential guide to construction job costing.

Indirect costs in materials procurement

Material costs constitute any money spent on items used to complete the job: paint, lumber, bricks, concrete, metal, etc. While everyone understands that you must allocate materials costs to jobs, several factors go into securing materials that incur costs outside of the direct purchase of the material itself (think back to the first-time car owner–the cost is always more than the sticker price).

These indirect costs can include time spent sourcing, importing, and transporting materials. Transportation stands out as an often overlooked cost for many projects. Picking up materials and delivering them to a job site can add meaningful labor time, and therefore cost, to your jobs. If not accounted for during the budgeting phase of a project, these costs can impact a job’s profitability. Transportation costs will fluctuate depending on distance, mode of transportation, and the materials themselves (e.g., heavy materials typically cost more to transport).

Visibility plays a key role here. Failure to track and account for material purchases can lead to repeat orders, excess materials, and a cluttered job site. If you aren’t paying attention, things can quickly get out of hand.

You might not think it’s a big deal to buy another ladder, but when you have five new ones sitting around unused, those costs add up quickly. And since they’re sitting around unused, they aren’t helping you get the job done any faster or more efficiently. Additionally, repeat orders can lead to billing mistakes and slow POs that stack unnecessary fees and expenses. Not to mention that this could cause tension with your suppliers.

Unfortunately, you also need to account for material theft. There were over 11,000 burglaries from job sites reported in 2021 alone. While valuable equipment is an obvious target, many of the reported burglaries were for common building materials such as metal wiring, bricks, lumbar, and more.

As material costs continue to rise, common building materials have become more vulnerable to thieves. When factoring in production delays, it goes without saying that theft can have a major impact on projects. The cost to secure a job site will be minuscule compared to stolen materials or equipment that completely derail a project.

To mitigate theft impacts, create a security plan:

  • Ensure your job site is always secured.
  • Consider installing CCTV cameras. 
  • Install a security fence.
  • Assess security risks ahead of time:
    • Is this a high crime area? 
    • Are you working with valuable materials? 
    • Who is responsible for securing different aspects of the job?

Indirect equipment costs

Direct and indirect equipment costs will vary depending on whether the equipment is owned or rented. If rented, then the direct costs are clear: the rental and fuel expenses (if applicable) are generally straightforward, and should be included in your job costing. And since you don’t have to pay to maintain rental equipment, the indirect costs tend to be negligible. Owned equipment can be a bit more complicated.

We recommend getting your accountant to do an analysis for you to turn the depreciation expense, insurance costs, and expected maintenance costs for a particular piece of equipment into a combined hourly rate for that equipment. You would then capture those costs on your jobs via a timecard. Fuel will continue to be a direct costs, so that’s more easily captured. 

We also encourage you to allocate costs associated with loading, transporting, and unloading equipment to your jobs.

Indirect G&A costs: manual vs. digital processes

While this guide has mostly focused on indirect costs in construction that should be allocated to your jobs, we felt we’d be remiss if we didn’t mention one significant, often-overlooked source of indirect costs to your general and administrative department: the amount of time spent searching for the information you need to make decisions, especially if you’re relying on pen and paper instead of software/apps.

When you’re a young business with a small team, it’s easy to overlook the amount of time you spend on admin work. But as you grow your team and take on more or larger projects, the hours start to add up.

As contractors scale their business, they inevitably transform from an army of one to a fully-fledged business that brings new employees, bigger facilities, better equipment and tools, and company vehicles. All of those changes inevitably bring more administrative work, and often (unfortunately) increasingly siloed, non-transparent processes.

Finding the information you need to run your business and make it more profitable over time can be very challenging–it can reside on a project manager’s laptop, or in an estimator’s inbox–not exactly at your fingertips.

Modern software can be very helpful here, providing you the infrastructure you need to maintain full visibility over your business as it grows. But making the transition from manual to digital doesn’t always happen organically.

In fact, nearly half of all construction managers rely on manual data entry to capture critical pieces of information; and while it may be the way you’ve always done things, manual processes will leave bags of money on the table.

Manual purchase orders, by-hand invoice processing, and scattered job costing can waste hundreds of hours per year. In addition, manual data entry often results in constant back-and-forth communication to validate data, only for all data to be reentered or changed after the fact.

Digital tools allow for automated procedures that bring real performance improvements almost immediately. This fosters the ability to better track costs, review financial reports, and organize data to create a historical database. A lack of historical data makes analyzing or searching for information across jobs nearly impossible.

In addition, this disorganization makes it challenging to hold vendors, workers, and general contractors accountable. As a result, contractors can set themselves up for a better financial future by ditching antiquated or by-hand accounting methods.

Manual processes can lead to the following:

  • Excessive time spent on administrative tasks
  • Siloed information
  • Inaccurate data
  • Data re-entry
  • Lack of transparency
  • Reduced bottom-line

This isn’t to say that all manual processes are detrimental to running a successful business. On the contrary, many contractors have relied on paper-based business processes and created functional, profitable businesses.

However, this can only lead a business so far. Eventually, there is a point of diminishing returns that can only be solved through digital solutions. Information is the lifeblood of the modern construction industry.

Construction management software enables contractors to collect, organize, analyze, and use information to direct their business wherever they see fit. The best part is that you don’t have to be a software developer to use these tools. Many tools, such as Knowify, are built specifically for specialty contractors, with ease of use in mind. With the right know-how and practice, contractors can take advantage of digital tools to take their business to new heights.

Final thoughts

Indirect costs relevant to your job costing can be found throughout your business. By identifying them and properly allocating them to your jobs, you’ll get a much more realistic view on your job-level profitability, allowing you to plan for your business’s needs today and off into the future.

Financial success begins and ends with a strong job costing system. As we discussed, manual processes and lack of visibility can cost a business thousands of dollars. This is why Knowify set out to provide contractors with a system that allows for real-time visibility into finances so that you can quickly identify and address unexpected expenses and evaluate past jobs to better plan for the future.

Additionally, Knowify provides contractors with tools to track and manage their cash flow, allowing them to make more informed decisions about their financial health.

Schedule a 30-minute demo and start taking control of your finances today!