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Indirect Cost Series: Part Five – Additional Considerations

This is part five of a five-part series on indirect costs.

As we wrap up our series on indirect costs, it’s important to remember the key takeaways from parts one through four:

  • Indirect costs are costs that are directly attributed as construction costs but are not easily identifiable to specific contracts.
  • Indirect costs must be allocated in a systematic, rational, and consistent way by accumulating them into cost pools, then allocating based on cost drivers that have a strong relationship with the incurrence of costs.
  • Project bids should include estimated allocated costs to maximize contract price, which, in turn, will maximize profit.
  • Accurate budgeting must include the proper allocation of indirect costs in the budgeted amounts to accurately project revenue, costs and profit for each period.

In addition to the above points, the following items should be considered when evaluating indirect costs:

  • Tax Considerations – Generally Accepted Accounting Principles (GAAP) and the Internal Revenue Code (IRC) share similar treatments of indirect costs . The difference arises with the definition of indirect costs. The IRC has a bright line test that specifically notes what comprises indirect costs, whereby GAAP is governed by the Financial Accounting Standards Board’s (FASB) codification of what an indirect cost is.
  • Incorrect Allocation of Indirect Costs – If indirect costs are not properly allocated to jobs and charged to general and administrative expenses, the following items will occur:
    • Estimated contract costs and costs incurred will be understated, leading to an inflated gross margin on the project.
    • General and administrative expenses will be overstated.
    • Indirect costs will be under applied causing management reporting to not be accurate.
  • Federal Acquisition Regulations (FAR) & Cost Accounting Standards (CAS)  Considerations – If you are working on a federal contract governed by FAR or CAS, there are multiple rules regarding allowable and unallowable indirect costs and indirect cost rates that may apply to your construction business . Unallowable costs are often legitimate costs incurred by your business; however, they are costs related to doing business that the government will not reimburse you for as part of your contract (e.g., penalties, interest, meals and entertainment, and certain legal costs). You are not alone; many contractors doing business with the government incur these costs and are subject to these regulations and cannot include any unallowable costs in their billing, proposal or claim to the government . In doing so, you could be assessed penalties and fines. The regulations are rather lengthy and can be complex. Compliance is a must and you need to be sure that you have the right accounting system and practices in place.

Though considering indirect costs in your construction contracts may seem like a no-brainer, these costs can be overlooked since they may be related to all projects but not easily allocated to just one.    A concerted effort should be made to accurately estimate, allocate, and track these costs on a job-by-job basis to ensure accurate financial reporting, budgeting, and to remain in compliance with GAAP and other standards (FAR, CAS, etc.) that could be applicable to your construction business.

For more information regarding indirect costs and construction contracts, please contract Chris Fischer of Aronson’s Construction Real Estate Group at 301.231.6200.

Indirect Cost Series: Part Four – Over/Under Application of Indirect Costs

This is part four of a five part series on indirect costs.

Audit professionals typically approach financial statement information from an external reporting viewpoint . With most contracts, we review a client’s position as of their year-end date. From a cost accounting perspective, however, contracts should be looked at monthly to determine accurate contract status. This includes comparing actual costs incurred (including direct and indirect costs) to budgeted costs to determine variances. This brings us to the concepts of “under application” and “over application” of indirect  costs. If indirect costs are under applied, it means that the actual amount of overhead exceeded the amount applied for the period, which would be the amount you budgeted for the period . Additionally, indirect costs would be over applied if the actual amount of overhead was less than the amount estimated for. Consider the following scenario:

  • Contractor XYZ budgeted $1,000,000 for estimated allocated indirect costs for Project A, which is a two-year project beginning on January 1, 2015
  • $50,000 was budgeted as indirect costs applied to Project A in January 2015
  • Actual indirect costs allocated in January 2015 were $60,000

Since actual indirect costs allocated to Project A in January 2015 were $60,000 and budgeted costs were $50,000, indirect costs were under applied. As a result, there was an unfavorable variance of $10,000. Note that this additional $10,000 of costs in January 2015 will also affect revenue recognized for contractor using the percentage of completion method for long-term construction contracts. The following scenario demonstrates the implications to the contract:

  • Total Contract Price: $14,300,000
  • Total Estimated Contract Costs: $13,000,000
  • Assume that, in addition to $60,000 in indirect costs, an additional $100,000 in direct costs were incurred in January of year one, which equaled the budgeted amount of $100,000

CREG-Chart-4

  • Note that estimated costs to complete are adjusted upward from $13,000,000 to $13,010,000 to include the increase in allocated indirect costs of $10,000

As you can see, the increase in the costs incurred in January 2015 will increase revenue recognized by approximately $11,000 when compared to revenue recognized in your budget. Comparatively, this is not a large acceleration of revenue recognition as compared to the budget. However, it is very important to employ good estimating and budgeting techniques to ensure that variances are minimal when compared to budgets to accurately project the status of contracts and to ensure that profit is maximized on projects.

Our final article in this indirect cost series will focus on miscellaneous indirect cost items that all contractors should be aware of for their projects. For more information on indirect cost application in budgeting, please contact Chris Fischer of Aronson’s Construction and Real Estate Group at 301.231.6200.

Indirect Cost Series: Part Three – Contract Estimation and Change Orders

This is part three of a five-part series on indirect costs.

In part two of our indirect cost series, we focused on developing cost pools and indirect cost rates to apply to contracts. In part three, we examine indirect costs in relation to contract estimation and change orders.

When estimating a long-term construction contract, costs to consider include direct material, direct labor, direct subcontractor, and other direct costs plus indirect costs multiplied by a target markup. In this calculation, contractors may overlook indirect costs, as they aren’t directly identifiable with the job. However, these costs must be taken into consideration to avoid underestimating costs attributable to the project and, therefore, underestimating your profit. In project estimation, the allocated indirect costs are determined by projecting total indirect costs estimated to be incurred over the life of the project, then allocating from cost pools using the appropriate allocation rates (discussed in Part Two). Take the following scenarios:

  • Background:
    • Contractor XYZ is preparing a bid for Project A
    • Estimated Costs are as follows:
      • Direct Labor: $1,000,000
      • Direct Material: $1,000,000
      • Subcontractor Costs: $10,000,000
      • Allocated Indirect Costs: $1,000,000
      • Target Markup: 1.4
  • In Scenario One below, indirect costs are included in the bid estimation; in Scenario Two, they are excluded:

CREG-Chart-3

  • Note that, in Scenario Two, the project has been underbid by $1.4 million, thus reducing estimated gross profit on the job from $5.2 M to $3.8M (including the indirect costs estimated to be incurred). Scenario 1 accurately reflects the cost of the project multiplied by a target markup of 1.4.

As you can see in the scenarios above, accurate estimation, which includes indirect costs, leads to a more accurate bid on the job and a higher profit margin. Additionally, the same approach should be taken into account when determining change order amounts. Any exclusion of indirect costs in the change order calculation will leave profit on the table.

With this information in mind, it is imperative that a contractor takes into account indirect costs in bidding for projects to ensure that profit is maximized. Stay tuned for part four of our five part series on indirect costs, which will focus on the over and under application of indirect costs in cost accounting. For more information on indirect costs in contract estimation and change orders, please contact Chris Fischer of Aronson’s Construction and Real Estate Group at 301.231.6200.

Indirect Cost Series: Part Two – Cost Pools and Developing an Indirect Cost Rate

In part one of our indirect costs series, we focused on what indirect costs are and why they are important to contractors. In this post, we will discuss cost pools and how to develop an appropriate indirect cost rate to allocate indirect costs to your construction projects.

As discussed previously, indirect costs are costs that directly arise from contracts but are not easily attributable to individual projects. Due to this, a rate must be determined to allocate these indirect costs to particular jobs. Before determining a rate you must determine how to accumulate indirect costs into cost pools.

Understanding Cost Pools

A cost pool accumulates similar indirect costs to be allocated to individual projects based on the indirect cost rates developed. Examples of cost pools include equipment, labor burden, vehicles, etc. In developing and tracking cost pools, a company must ensure that the money attributed to cost pools are truly indirect costs and not direct costs or general and administrative costs.

Indirect costs must then be allocated in a consistent way once an indirect cost rate has been established. Examples of rates include those based on direct labor costs, direct labor hours, or equipment usage hours. These cost drivers should be matched to cost pools that have a strong relationship with the incurrence of these costs. Take the following scenario (expanding on the example in Part One):

  • Contractor XYZ has the following projects in 2015:
    • Project A and Project B
  • At the end of 2015, Contractor XYZ incurred $250,000 in indirect costs related to depreciation and repairs and maintenance for construction equipment used on both jobs.
  • The cost driver matched to the equipment cost pool in this scenario should be equipment usage hours.
  • If Project A has 4,000 equipment usage hours and Project B had 6,000 equipment usage hours, then the $250,000 would be allocated as follows:

cisg-chart-1

Alternatively, using the same data, Contractor XYZ could have allocated the indirect costs using an indirect cost rate based on the equipment hours incurred throughout the year, compared to waiting until year-end to allocate the costs. The following example demonstrates this scenario:

  • At the beginning of 2015, Contractor XYZ originally estimated that $230,000, of indirect costs would be incurred related to these expenses and the equipment would require about 10,000 usage hours during the year . This would provide an indirect rate and allocation as follows:

cisg-chart-2

This scenario provides a total of $230,000, of indirect costs allocated to the job when a total of $250,000 of costs was incurred. The contractor could decide to reallocate the costs to the projects or if total costs incurred where not material, the contractor could attribute the difference as under-applied. A contractor’s specific circumstances will determine what treatment is best.

Additional examples of matching cost pools to cost drivers include:

  • Allocating labor burden based on direct labor hours
  • Allocating liability insurance based on total direct costs
  • Allocating quality control based on direct labor hours

Correct indirect cost allocation is vital for accurate financial reporting, both internal and external, and to portray an accurate picture of contract status. Stay tuned for part three of our five part indirect cost series, “Indirect Costs – Contract Estimation and Change Orders”. For questions relating to the development of cost pools and indirect rates, please contract Chris Fischer of Aronson’s Construction and Real Estate Group at 301.231.6200.

Indirect Cost Series: Part One – What Are Indirect Costs?

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

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.

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