What Are Indirect Costs in Construction? How Should They Be Managed?

Expense management
Zaid Rahman
October 26, 2021
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Table of Contents

Materials. Labor. Equipment. Subcontractors.

Trying to keep track of costs in the construction industry can be mind-boggling.  

And how do you determine what’s a direct cost, and what's an indirect cost?

If you're confused about how to manage costs in your construction business, read on. This article will discuss direct and indirect cost in construction, so you can be sure you are bringing in top profits.

Flexbase: Seamlessly Integrating With Your Accounting Software to Track Indirect Costs Is One Part of Our Cash Flow Management Solution

Keeping up with direct and indirect cost in construction can get complex. 

Honestly, it can be a huge headache. This is where Flexbase shines.

Flexbase integrates with your accounting software to track all your costs.

Plus, contractors can use Flexbase to: 

  • Create invoices
  • Send invoices
  • Track projects
  • Automate all documents
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And Flexbase is completely free to use, so you can put an end to subscriptions that you have to pay for even when you don’t get paid.

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What Is an Indirect Cost in Construction?

Indirect cost in construction is any expense that is not specifically related to a particular project, but is required as a part of the construction process. Generally, indirect costs benefit multiple projects simultaneously and will vary at times, depending upon the volume of work. 

What Are Direct and Indirect Costs in Construction?

The easiest way to distinguish between direct cost and indirect cost in construction is that direct cost refers to the expenses specific to the construction project, and indirect costs are any expenses that remain.

Direct Costs in Construction

Direct costs are also known as project overhead costs and are the expenses that are directly linked to the physical construction of the project. 

Sometimes also referred to as “unburdened” or “bare” costs, direct costs include:

  • Material
  • Labor
  • Equipment; and
  • Subcontractor costs

Direct costs are very specific and are generally easy to assign to a specific construction contract. 

Indirect Costs in Construction

In contrast, indirect construction costs cannot be specifically allocated to contracts. 

The following are typically included as indirect cost in construction:

  • Insurance
  • Safety and PPE
  • Overhead, including:
  • Job site costs
  • Office trailers
  • Office equipment and supplies
  • Project-related software
  • Insurance 
  • Office salaries
  • Project managers
  • Superintendents; and
  • Support staff
  • Equipment and vehicle costs, including: 
  • Maintenance
  • Insurance
  • Depreciation
  • Taxes; and
  • Fuel
  • Payroll details — including health insurance and employer-paid taxes
  • Taxes
  • Workman’s compensation

Why Is It Important to Understand Indirect Costs in Construction?

If you're a business owner, understanding the difference between direct and indirect cost in construction will help you to:

  • Have a better understanding of your service or product — which leads to the ability to price competitively.
  • Have a better overall grasp of your accounting — thus allowing you to better plan for the future of your business.

And not only that, but having a good understanding of indirect cost in construction is also hugely helpful when tax time rolls around. Some indirect costs — as well as some direct costs — are tax-deductible. 

Tax-deductible indirect costs may include things such as:

  • Rent payments
  • Some insurance costs; and
  • Utilities

Of course, every company’s situation will be different, so be sure to consult with your accountant to see exactly what qualifies for your situation. 

How to Allocate Indirect Construction Costs: 6 Steps

Now that we’ve answered the question, “What are indirect costs in construction,” we need to decide how we’ll go about allocating those costs.

While indirect cost in construction doesn’t relate to specific projects, it still needs to be equally distributed between all of your projects and included in your overhead expenses. Indirect costs affect your gross profit on projects and must be considered when calculating the overall profit. 

When it comes right down to it, how the costs are allocated is not nearly as important as making sure that they are consistently allocated on a regular basis.

#1: Define and Classify Your Indirect Costs

Indirect costs are harder to classify. 

We've determined that indirect costs can't be directly allocated to a specific project, and costs sometimes cover multiple projects.

An easy way to keep track of indirect costs is to create different cost pools to help you categorize your indirect costs. 

For example, you may choose to allocate your indirect costs in the following categories:

  • Labor hours: A contractor who mainly provides labor may want to allocate indirect costs according to the number of labor hours in a period.  To do this, you would simply run reports showing the total indirect costs and the total labor hours for the project, and divide the hours into the cost to determine the cost per hour.
  • Labor costs:  In this case, you would divide the total labor costs into the total indirect costs in order to get the percentage of indirect costs. Next, take the percentage and multiply it by the labor costs per project. This additional amount should be allocated to each of your projects. 
  • Equipment hours: If your company chooses to allocate cost by equipment, then you would calculate similarly to the labor hours, but substitute equipment hours instead.
  • Materials costs: If you were a contractor or supplier providing mainly just materials, you may choose to base your allocation on materials cost. The calculation would be similar to the labor hours, but you would substitute materials cost instead.

#2: Determine How Allocation Affects Job Costing

Job costing refers to a method of calculating the actual cost of working on a project. It takes into consideration the overall project, breaking it down into smaller, specific tasks.

This is beneficial throughout the entire life of your project — from bidding to knocking out the punch list.

The truth is, if you don't have proper job costing, anything else you're doing will just be a shot in the dark. 

#3: Create a Systematic Allocation Method

As a contractor, there are quite a few methods you can choose from to allocate your indirect costs, such as:

  • Total direct costs
  • Direct labor hours
  • Labor hour percentages; and 
  • Various equipment method rates

The important thing is that whatever method you choose, it must:

  • Be systematic
  • Be rational
  • Reflect your company's operations; and
  • Be applied consistently

#4: Track Indirect Costs

Tracking data gives insight, and by tracking your indirect costs, you will have a more accurate look at the profitability of a given project. 

Successful tracking of indirect cost in construction will help you maintain accuracy when it comes to:

  • Having a clear picture of your real cost for each contract
  • Compiling your bids; and
  • Accurately estimating cost for any future projects

#5: Know Your Accounting Software

You'll also want to take a good hard look at your accounting software. 

Is it capable of distributing costs the way you want it to? 

Can it track your indirect — and direct costs — and apply allocation in the ways you need it to do? 

The Flexbase cash flow management system can.  

Our app easily integrates with your accounting software to track both your direct cost and indirect cost in project management.

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#6: Create a Policy Rate Adjustment Protocol

If you’ve been in the construction industry for more than a minute, you know just how quickly things can change. 

This is why you need to evaluate your rates, at least quarterly, for accuracy. 

If you notice an accumulation of over or under-applied cost pools on your financial report, then you’ll need to take a closer look in order to determine if adjustments should be made. 

Of course, you will want to keep in mind that there can be seasonal variations in projects that may lead to temporary over or under-cost accumulation. 

Additionally, payouts of project manager bonuses or making bulk purchases of non-inventory supplies can also cause temporary fluctuations. In these situations, it may be unnecessary to adjust rates

Common Mistakes When Labeling Indirect Costs

When you're working on labeling indirect costs, you want to be sure to avoid some pitfalls. Common mistakes contractors often make include:

  • Failing to consider indirect cost in construction bids; and
  • Neglecting to allocate indirect costs in a timely manner — such as doing them annually rather than monthly

Keeping up with all the costs by maintaining quality records is the best insurance you have when it comes to avoiding potential problems.

Keeping track of your direct and indirect cost in construction can be time-consuming and tricky, but Flexbase can help you stay on top of costs and spending and improve your profit margins.

How to Get Paid for Indirect Costs

Indirect construction costs affect your overall project cost totals, and if you want to be sure that you're getting paid for them, you need to make sure they are included in your bids. But before you can do that, you have to know exactly how much your indirect costs are costing you.

This is why tracking your indirect costs is so critically important, and you can do that by setting up general ledger accounts to track your individual indirect costs. Once you've accumulated about three months’ worth of tracked costs, you can begin to allocate those totals to your active projects within that time frame. 

Of course, you will want to be sure to recalculate your indirect cost allocation each time you allocate cost since your indirect costs will vary depending on how busy you are at that time. 

And just to be sure that you receive your payment for indirect costs, remember to always protect your payment rights by filing the correct notices and a mechanic's lien, if necessary. 

Better Manage Indirect Costs With Flexbase

Flexbase takes the hassle out of managing your indirect costs.

Let us take care of all your construction paperwork, including:

  • Receipts
  • Project tracking
  • Construction budget
  • Applications for payment
  • Legal reminders
  • And much, much more

The Flexbase platform integrates fully with the accounting software you already use, so your transition will be seamless.

Our resources are 100% free to use. You don’t pay Flexbase unless you get paid.

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