This is part one of a five-part series on indirect costs.
When contractors are accounting for contracts, it’s easy to account for the typical project costs that come from an invoice for tangible materials delivered to a site. However, other costs, known as indirect costs, are often forgotten in the planning and budgeting process. In a five-part series, we will explore the reasons why indirect costs are just as important, not only for a job’s success, but also for your company’s overall success.
In this initial article, we will delve into the definition of indirect costs and how they contribute to your overall profitability.
Direct Costs and General/Administrative Expenses
To define indirect costs is to first understand which items aren’t indirect costs: direct costs and general and administrative expenses. Direct costs are costs that can easily be directly identifiable with or attributable to a particular job. Examples of these costs include direct materials, direct labor, and subcontractor costs. For instance, a direct subcontractor cost is easily traceable to a job because the subcontractor would submit invoices from the particular job that they are working on.
General and administrative expenses unrelated to contract activity, such as general legal and banking costs are neither direct nor indirect costs, and are typically incurred regardless of whether or not a company has active contracts. Both direct labor and general and administrative costs are easily identifiable, whereas indirect costs are more difficult to determine.
Indirect costs are expenses that are directly identifiable as costs of construction but are not easily attributable to specific contracts. Examples include labor not directly attributable to any one job (i.e., a project manager working on multiple jobs in the office), contract supervision, tools and equipment, supplies, quality control and inspection, insurance, repairs and maintenance, depreciation, and amortization.
When compared to general and administrative costs, indirect costs would not continue to be incurred if the company had no contracts. For example, if a company had no contracts, then the machinery and equipment used on jobs would not incur any additional wear and tear; hence, no additional repair and maintenance costs. Take the following scenario:
- Contractor XYZ incurs the following costs in 2015:
- $500,000 direct labor
- $1,000,000 direct material
- $10,000,000 subcontractor costs
- $200,000 depreciation expense on construction equipment used on multiple jobs
- $50,000 repairs and maintenance on construction equipment used on multiple jobs
- $20,000 banking fees
- $10,000 general legal fees
- The above costs would be classified as follows:
- $11,500,000 of direct costs – direct labor, direct material, & subcontractor
- $250,000 indirect costs – depreciation expense & repairs and maintenance
- $30,000 general and administrative costs – banking & general legal fees
In the example above, depreciation and repairs and maintenance are indirect costs because the equipment is used on multiple contracts and the amount for each contract is not easily determinable. Note that the indirect costs would be distributed among Contractor XYZ’s contracts based on an allocation rate, which will be discussed in part two of our indirect cost series.
“Why should I care about indirect costs?”
Proper cost allocation is important for a multitude of reasons, including:
- Financial Reporting |Indirect costs must be properly accounted for and allocated to contracts in order to properly recognize revenue earned.
- Budgeting & Estimating | Indirect costs must be included to present an accurate picture of contract status and profitability for internal and external purposes.
- Banking & Bonding | If not properly accounted for in your financial statements, banks or bonding companies may question why your general and administrative costs are high compared to industry averages.
- Overall Financial Status | If you are not tracking indirect costs correctly, you won’t have a clear picture of your business. High indirect costs can break your business, and low indirect costs can make it.
As you can see, it is crucial for your construction business to properly account for indirect costs in order to have a long, profitable existence. Look out for the next article in our five part series on indirect costs, which will focus on developing an indirect cost rate. For more information on indirect costs and why they are important, contact Chris Fischer of Aronson’s Construction and Real Estate Group at 301.231.6200.