Wouldn’t it be great to know exactly how much profit will be made going into every bid on every job? In a perfect world perhaps it could be known, but this isn’t a perfect world. One of the biggest stress factors business owners have is uncertainty, and the construction industry definitely has its fair share.
One, if not the most, significant aspect that contributes to uncertainty in construction is estimating how much profit the contractor is going to make when bidding on a new job. Am I going to capture all of the hard costs? What about the contingency factor? Oh, and let’s not forget about the indirect costs that add another layer of uncertainty to the equation. Without a complete understanding of costs, direct and indirect, contractors could be selling themselves short in a number of different ways when going into a new bid on a project.
The accounting behind a construction estimate is relatively simple. Take known costs plus indirect costs, add a contingency for the unknown (based on historical averages, of course) and then mark-up for profit. However, those indirect costs can entail a number of different line items that can become difficult to estimate.
Calculate Burden
There are numerous methods used to calculate burden when estimating a project, as well as when burdening the project as it progresses through its lifecycle, depending on the type of contractor (e.g., labor hours, equipment hours and variation of both). In today’s market, when profit margins are still struggling to move north, it is more important than ever to fully understand the burden rates used and what goes into them. This comes into play not only when bidding on projects, but also when analyzing a project’s profit and understanding why jobs have gains or fades as the job progresses through its life.
Let’s assume the bid spread on a new job is ,000 on a ,000,000 contract, and the contract will be awarded to the lowest bidder. Included in the estimate is equipment burden of ,000,000 (including items like depreciation expense, repairs and maintenance, and insurance), which was calculated using the historical equipment burden rates used by the company’s former CFO who retired 10 years ago (and have not been analyzed since). At the end of the estimate, the contractor will add a 10 percent markup for profit, which is what the contractor historically estimates based on its business model. With those facts, let’s assume the actual burden for equipment, based on the company’s current indirect equipment costs, is actually ,500,000—a 0,000 difference. Using the correct burden rate would have lowered the bid by ,000 and could have resulted in the company getting the contract.
How can a company still make money by reducing its bid by $50,000, especially in this market? While trying to keep to the context of only indirect costs and burden rates (because the full answer is probably a novel in itself), if the company’s actual indirect costs are lower than the outdated burden rate used when calculating the bid, the company’s profit is not actually being impacted at all. It is like putting together an estimate and including a line item for an electrical subcontractor to wire two floors when the bid is only asking for one floor. That said, the same holds true when an estimate includes a lower-than-necessary burden rate or no burden at all.
This scenario, as unfortunate as it is, happens more often than not. Many contractors do not have the resources for an accounting department to calculate and monitor their burden rates on a regular basis. This results in bids being marked up at the same 10 percent, but only including a small portion of indirect costs or not including any indirect costs at all. As the job progresses, margins consistently fade and trying to keep profit margins high enough to cover overhead costs becomes a problem. This is a common problem, mostly shared by the operational team because the only costs the project managers are seeing are the hard costs (materials, supplies, payroll and subcontractors). They do not see the repairs and maintenance costs incurred behind the scenes not being allocated to their job. Although their question is the reverse of the first scenario, the answer is always the same. It is like selling yourself short when estimating a job. If a contractor is only including half the costs then it is not going to make 10 percent—it will make 5 percent.
Job burden is a topic of many discussions and can be an extremely useful tool for a company to fully understand, especially when looking for areas that can help lower bids or reduce costs without having to cut the experienced personnel. Having open lines of communication between the accounting department and operational department is also a key take away, so a full understanding of what it takes to get the jobs completed is obtained. Of course, it is always recommended to consult an accounting professional when dealing with accounting matters.
