Don't misinterpret indirect costs when accounting for job contracts

By Randy Bonnecaze

The construction industry has long struggled with the inherent challenge of accounting for indirect contract costs. Why? Because when these expenses occur they often don't pertain to only one contract or because foreseeing what their actual amounts will be - such as with repairs and maintenance - may be difficult. Let's examine how you can better account for indirect costs to enhance your bottom line.

Make the distinction. The American Institute of Certified Public Accountants (AICPA) issued Statement of Position 81-1, "Accounting for performance of construction-type and certain production-type contracts," to guide contractors on the indirect costs problem and others like it.

In one paragraph, SOP 81-1 states, "Contract costs generally include direct costs, such as materials, direct labor, and subcontracts and indirect costs identifiable with or allocable to the contracts." More specifically, indirect costs may include:

• Contract supervision
  
• Tools, equipment and supplies
  
• Quality control and inspections
  
• Insurance
  
• Depreciation and amortization and
  
• Repairs and maintenance

Many contractors refer to these costs as "overhead," but this misnomer actually leads to a critical problem. That is, overhead encompasses general and administrative expenses, which include advertising, dues and subscriptions, office supplies, salaries, legal and accounting fees, office rent and utilities.

These costs are essential to your company's overall operation, are relatively stable and typically don't fluctuate as a percentage of work volume over time. Conversely, indirect costs are related only to contract performance. Thus under SOP 81-1 you should expense general and administrative costs as incurred and you shouldn't include them as indirect costs when estimating job completion.

Truth is, discrepancies frequently arise among contractors when distinguishing between general and administrative expenses and indirect job costs. The critical factor here is the work "identifiable." Examine overhead costs thoroughly and determine which ones you can identify to individual jobs (indirect costs) and which you can attribute to your company as a whole (general and administrative costs).

For example, you probably buy liability insurance via an annual policy and not on a job-by-job basis. Although 100 percent of this cost doesn't pertain to one individual contract, a portion of the total cost does and you should consider this an indirect cost. But the exact amount of this percentage will vary from contractor to contractor.

Allocate for best results. After you've separated them from general and administrative expenses, how do you allocate your jobs' indirect costs? SOP 81-1 says to use a systematic and rational approach, which includes allocations based on direct labor hours (or costs) and material costs.

The appropriateness of indirect-cost allocations, as well as the methods for determining them, depends on the circumstances and calls for your sound judgment based on a financial professional's advice.

To get started, identify the casual relationships between an expense and its driving force. For instance, repairs and maintenance on equipment is most likely driven by the equipment-usage time. So an appropriate allocation of repairs and maintenance expense may be hours of owned equipment use on a particular job.

How might this work in practice? Well, indirect repair costs are typically expenses on a construction company's books when the cost is incurred. So when you use a piece of equipment on a project, you could charge a predetermined hourly rate (typically for each hour of equipment use) to the respective job.

This would account for repair expenses that occur over time because of using the equipment and not charging these costs within a project's scope. But, because this expense is just an estimate to reflect an indirect cost within a job's gross profit, the other side of this accounting entry would be to a "contra-expense" account, thus having a zero income statement effect.

Analyze job by job. Having allocated your indirect costs to specific jobs, you must then analyze profitability by job to determine whether you're maintaining adequate profit margins. If you don't correctly factor indirect costs into your job-profitability calculations, you'll likely overstate job projects, and future bids won't adequately cover these unaccounted-for-costs.

In addition, reflecting indirect costs through job cost will allow you to more accurately estimate revenues earned through adjustments to costs in excess of billings and billings in excess of costs. If this adjustment is incorrect, your revenue will be incorrect - distorting the gross profit for the job in question and your construction company as a whole.

Ultimately, underestimating indirect costs when bidding usually leads to contract losses, while overestimating may prevent you from obtaining new jobs in today's competitive market. So an understanding of the relationship of indirect costs to your individual jobs is key to ensuring profitability.

Stay alert always. Because indirect costs will fluctuate over time, adjust estimating factors accordingly. For proof of these fluctuations, just look at the current state of the insurance and surety business. With policy and bonding costs on the rise, and indirect-cost estimating formulas becoming outdated so quickly, make sure to revise and test your accounting methods periodically to maintain accuracy.

Editor's Note: Randy J. Bonnecaze is a Certified Public Accountant (CPA) with Hannis T. Bourgeois LLP, Baton Rouge.