Direct Vs.

Indirect Costs in Construction

How to Calculate Construction Overhead and Profit

DIRECT vs. INDIRECT COSTS IN CONSTRUCTION

Financial management plays a crucial role in the construction industry's success. Direct
costs and indirect costs are two important concepts in the financial ecosystem of
construction projects. Understanding the difference between these job cost categories
can help construction professionals make informed decisions, budget effectively and
improve project profitability. This article will explore the details of direct and indirect
costs and how they affect construction projects.
WHAT IS A DIRECT COST?

Direct costs are expenses that can be traced directly to a specific construction activity,
task or project. These costs are the building blocks of any construction project, forming
the foundation upon which the entire financial structure is erected. Direct costs are often
referred to as project costs.
EXAMPLES OF DIRECT COSTS
Common examples of direct costs include:

Cost type Description

Labour cost Wages and salaries of on-site workers directly involved in

construction activities.

Burden The cost for employer payroll taxes such as FICA, FUTA, SUAT,
workers comp and fringes such as employer paid benefits like PTO,
health insurance, pension, and 401k matching.

Materials Expenses related to raw materials, components and supplies used in

the project.

Equipment costs Charges associated with rented or owned equipment utilized for
project tasks.

Subcontractor Payments made to subcontractors hired for specialized services.

payments

Site preparation Costs associated with preparing the construction site, including
costs excavation, grading, clearing and any necessary demolition.

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Cost type Description

Permits and fees Fees paid to obtain necessary construction permits and licenses
from regulatory authorities.

Temporary Costs related to setting up temporary structures on the site, such as

structures scaffolding, temporary fencing, job site trailer and portable
restrooms.

Expenses associated with direct construction project

Direct project management, such as the salaries of project managers and site
management supervisors dedicated to overseeing the project.
costs

Transportation Costs related to transporting materials, equipment and workers to

costs and from the construction site.

Safety Expenses for safety equipment and gear required for workers on the
equipment construction site, including helmets, gloves, safety glasses and
harnesses.

Testing and Fees for tests and inspections required to ensure compliance with
inspection costs building codes and quality standards, such as soil testing, structural
inspections and fire safety inspections.

Land acquisition Costs associated with purchasing or leasing the land where the
costs construction project will take place.

HOW TO CALCULATE DIRECT COSTS

The formula to calculate direct costs is relatively straightforward. Direct costs are the
sum of all expenses directly attributable to a specific project, task or activity.
Mathematically, it can be represented as:
Direct Costs = Labour Costs + Material Costs + Equipment Costs + Subcontractor
Payments + Other Project Specific Costs
WHAT IS AN INDIRECT COST?

Indirect costs are not directly attributable to a single construction task or project.
Instead, they support the overall project environment, playing a critical role in its
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successful execution. Indirect costs are often referred to as overhead costs or operating
expenses.

EXAMPLES OF INDIRECT COSTS

Common examples of indirect costs include:

Cost type Description

General overhead Expenses related to the general operation of the

construction company, including office rent, utilities
(electricity, water, heating/cooling) and office supplies.

Administrative Salaries of administrative staff who manage tasks not

salaries directly associated with project execution, such as human
resources, accounting, marketing and management. This
also includes benefits for administrative staff like PTO,
health insurance, pension, and 401k matching.

Office equipment and Costs associated with purchasing and maintaining office
furniture equipment, furniture, computers and software, used by
administrative and management staff.

Rent for corporate Rent for the corporate office space where management and
facilities administrative functions are carried out.

Utilities for corporate Utility costs for the corporate office space, including
facilities electricity, water, heating and cooling.

Costs for software licenses and subscriptions used for

Software licenses various business operations, including project management
and construction accounting software.

Travel and equipment Expenses related to business travel, client meetings and
entertainment for business purposes.

Quality control and Costs associated with quality control measures, inspections
assurance and testing to ensure projects meet industry standards and
regulations.

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Cost type Description

Legal and Expenses for legal services, consulting fees and other
professional fees professional services required for business operations.

Advertising and Costs related to marketing efforts, including advertising,

marketing promotions, website development and branding activities.

Corporate Expenses related to internal and external communications,

communications including internal newsletters, external publications and
communication tools.

Training and Costs associated with training programs, workshops and

development professional development opportunities for employees.

Taxes Various taxes paid by the construction company, including

property taxes and income taxes.

Interest on loans Interest payments on loans or lines of credit used for

business operations and investments.

Insurance premiums Premiums paid for various types of insurance coverage,

including liability insurance and property insurance.

Depreciation The gradual decrease in the value of company assets (e.g.,

vehicles, equipment) over time due to wear and tear.

Contingency reserves Funds set aside to cover unexpected expenses that may
arise during the course of business operations or
construction projects.

HOW TO CALCULATE INDIRECT COSTS

The formula to calculate indirect costs involves summing up all the expenses that are not
directly tied to a specific project or task but are necessary for the overall operation of the
business. Indirect costs are often expressed as a percentage of direct costs or as a fixed
amount.

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The formula can be represented as:

Indirect Cost Percentage = Indirect Cost / Direct Cost

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HOW TO TELL DIRECT COSTS FROM INDIRECT COSTS

Distinguishing between direct costs and indirect costs in construction involves

understanding the nature of the expenses and how they relate to specific projects or the
overall business operations. Here's a step-by-step guide to help you differentiate between
the two:

Direct Cost Indirect Cost

Identify the Is it directly associated Does the expense support the

expense: with a particular project, entire construction business rather
task, or activity? than a specific project?

Traceability: Can you easily trace the Is the expense not easily traceable
expense back to a specific to a single project but rather
project, job task or work spread across multiple projects or
order? the overall business?

Project Does the expense have a Does the expense affect the overall
impact: direct impact on the financial health and operational
budget, pricing or efficiency of the entire
profitability of a specific construction company?
project?

Allocation Can you allocate the cost Is the cost challenging to allocate
difficulty: directly to a particular to a specific project due to its
project or task without nature as a shared or general
ambiguity? expense?

Consistency Do the costs tend to vary Are the costs relatively stable over

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Direct Cost Indirect Cost

and stability: based on the scope and time, regardless of the specific
requirements of projects being undertaken?
individual projects?

Decision- Assess whether the Consider whether the expense

making expense impacts influences broader decisions
influence: decisions specific to a related to business expansion,
project, such as resource resource allocation and investment
allocation and task strategies.
prioritization.

By considering these aspects, you can effectively distinguish between direct costs and
indirect costs in construction. Careful classification and tracking of these costs are crucial
for accurate project budgeting, pricing, and overall financial management.
CONSTRUCTION ACCOUNTING GUIDE

PRICING AND PROFITABILITY

Understanding the distinction between direct and indirect costs is pivotal in determining
the optimal project pricing strategy and achieving profitability.
DIRECT COSTS AND PRICING

 Accurate pricing: Direct costs lay the foundation for determining the minimum price
required to cover project expenses and generate profit.
 Transparent bidding: Transparently accounting for direct costs in project bids fosters
credibility and trust with clients.

INDIRECT COSTS AND PRICING

 Inclusive pricing: Incorporating indirect costs ensures that the total expenses of a
project are covered.
 Competitive edge: A well-calculated balance of direct and indirect costs can lead to
competitive pricing strategies while maintaining profitability.

HOW TO MANAGE DIRECT AND INDIRECT COSTS

Effectively managing both direct and indirect costs is key to successful construction
project execution. Here's how:

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OPTIMIZING DIRECT COST MANAGEMENT

 Detailed budgeting: Create comprehensive budgets that account for labor, materials and
equipment expenses.
 Resource allocation: Allocate resources efficiently to minimize wastage and optimize
workforce utilization.
 Regular monitoring: Continuously monitor direct costs to detect discrepancies and
prevent overruns.

EFFICIENT INDIRECT COST MANAGEMENT

 Cost tracking: Maintain meticulous records of overhead expenses to ensure accurate

allocation.
 Automation: Utilize software tools, like DeltekComputerEase, to streamline
administrative processes, reducing indirect cost inefficiencies.
 Contingency planning: Set aside a contingency budget to account for unforeseen
indirect costs.

UNDERSTANDING FIXED COSTS AND VARIABLE COSTS

Fixed and variable costs are concepts in cost accounting that apply to both direct and
indirect costs. These concepts help categorize costs based on their behavior in relation to
changes in production levels or business activities. Let's explore how fixed and variable
costs relate to both direct and indirect costs:
FIXED COSTS
Fixed costs are expenses that remain constant regardless of changes in production levels
or business activities. These costs do not vary with increases or decreases in output.
Direct fixed costs are directly associated with a specific product or project.
For example, the salary of a project manager overseeing a particular construction project
is a direct fixed cost.
Indirect fixed costs are not directly attributable to a specific product or project but still
contribute to the overall business operations. An example could be the rent for the
corporate office space where various projects are managed.
VARIABLE COSTS
Variable costs are expenses that change in direct proportion to changes in production
levels or business activities. These costs increase as production or activity increases and
decrease as production or activity decreases. Direct variable costs directly relate to the
production of a specific product or the completion of a particular project.
For instance, the cost of raw materials for a construction project is a direct variable cost.
Indirect variable costs impact the entire business but are not directly tied to a specific
project or product. For example, utility costs (electricity, water) in a construction
company's office are indirect variable costs.

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RELATIONSHIP TO DIRECT
CT AND INDIRECT COSTS
COST

 Direct fixed costs: These costs remain constant regardless of the level of production or
business activity for a specific project. They are directly associated with a particular
project or product and do not change based on the quantity produced.
 Direct variable costs: These costs vary based on the quantity produced or the specific
project's scope. They are directly tied to the project's output and will increase or decrease
as the project progresses.
 Indirect fixed costs: These costs osts remain constant even when specific projects or
products change. They are typically related to overall business operations and are not
directly tied to the quantity of a particular project.
 Indirect variable costs: These costs vary based on the overall business activities but are
not directly traceable to a specific project. They might fluctuate with changes in
production levels or other business activities that impact the company as a whole.

START MANAGING YOUR DIRECT AND INDIRECT COSTS

In the construction
tion industry, a thorough understanding of direct and indirect costs is a
vital asset. Recognizing the role of each cost category in project pricing, budgeting and
profitability equips construction professionals to make sound financial decisions. By
effectively
ively managing both direct and indirect costs, construction projects can not only
achieve financial success but also foster long-term
long term sustainability and growth. As the
foundation of any construction venture, direct and indirect costs pave the way for a
brighter
ghter future in the world of construction.

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How to Calculate Construction Overhead and Profit

Your construction overhead and profit margins are two of the most important figures for your
business. Yet many construction companies aren’t calculating them correctly, leading to tight
budgets, slow business growth, and, in some cases, negative bank balances.

If you’ve been in the business a while, you’ll probably have heard of the 10-10 rule; it’s an
industry standard for calculating overhead and profit (O & P).

However, overhead and profits vary vastly between different company sizes, project types, and
businesses. For example, developers, remodelers, and custom builders all have different cost
structures.

On average, construction work can attract a margin of 17-19%, remodeling work 34-42%, and
specialty work 26-34%. However, if these figures don’t cover your direct costs or they price you
out of the competition, they’re of no use.

That’s why it’s crucial to accurately calculate your construction overhead costs and profit. Then,
you can use these figures to add the right markup and actually make money while staying
competitive.

What is overhead in construction?

Simply put, overhead refers to the costs associated with running a business. Examples include
basics like rent, utilities, and payroll. In the construction industry, specific overhead costs might
include:

 Executive and administrative payroll

 Employee taxes and benefits
 Insurance
 Professional fees such as marketing and accounting
 Occupancy and utility bills
 Telephone and technology
 Vehicle expenses
 Tools and equipment
 Legal and marketing
 Other office expenses

These are just a few examples of overhead costs. But, as you can see, there’s a lot to think
about when it comes to tracking overhead costs — and they have a huge impact on potential
profit.

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What is profit in construction?

Profit basically boils down to the amount of money left over after subtracting all overhead costs.
It’s important to find this difference on a project-by-project basis. From there, you can calculate
quarterly and annual profits for better forecasting.

As an example, if you have a $100,000 contract, we all know you wouldn’t be pocketing that full
100K. Let’s say you have $70,000 in labor and $5,000 in materials that you need to spend in
order to complete said project. You’d walk away with $25,000 in profit.

Over the course of a quarter, year, or lifetime of your business, you can calculate profit margins
by subtracting overhead costs and other expenses from your raw earnings.

The importance of correctly calculating your overhead and profit

Although adopting the industry standard for overhead and profit calculations is undoubtedly
easier, there are three reasons why calculating these numbers yourself is essential to the health
of your construction business.

1. Business management

Knowing your actual O&P enables you to run your construction business with confidence. You
know how to price jobs, how much work you need to win, and what core requirements your
business needs to function.

2. Business growth

Realistic O & P figures help you see where you can allocate money to different resources, such
as marketing, hiring, or adding new tools.

3. Business protection

Finally, a proper analysis of your overhead and profits allows you to keep your bank balance in
the green. You’ll be able to spot where you’re spending too much money and prevent yourself
from under-quoting jobs.

How to calculate your overhead and profits

There are many different ways to calculate your overhead and profit, but we’re going to look at
the most common methods.

Determine your construction overhead and markup

To calculate your construction overhead, add up the monthly fixed costs of running your
business. Some find it easier to add up your annual costs and then divide them by 12 to get your

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monthly expenses. The resulting figure is the amount of money you must make each month to
keep your business alive.

Note that your overhead does not include any direct project costs, such as materials or payroll
for field teams or other labor. That’s because you’ll only have those costs if you have work to do.

Once you’ve calculated your monthly overhead, you can determine your markup. This is a
percentage to add onto project estimates to cover overhead and keep your projects profitable.
There are two different methods of doing this: by labor cost and by sales.

1. By labor cost

To calculate your construction overhead by labor cost, divide your monthly overhead by your
monthly labor costs. This figure tells you how much of each dollar goes toward overhead.

Example A:

Let’s use some real numbers as an example. Imagine you have monthly overhead costs of $600
($200 insurance + $200 utility bills + $200 office supplies), and you’re the only employee. Let’s
say you pay yourself $15/hour and work 40 hours/week ($2400/month).

What does this mean? For every dollar you make, $.25 goes straight to overhead.

If you have multiple employees, your overhead percentage will decrease because you’ll be able
to spread your overhead across more projects as you take on more work.

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Since you have more crew members doing more work, you can afford to spread out your
overhead costs across more projects.

Note: This equation just shows what you need to charge on top of projects to cover your
overhead fees. It doesn’t include any profit margins you want to incorporate.

Example B:

Let’s say your overhead costs are $600/month, and you have two full-time employees: yourself
and someone else.

With that calculation, you know you should be adding at least 12.5% to your labor costs to cover
overhead.

Now, say you get two renovation projects that’ll take around two days each.

Using your calculation above, your total overhead markup will be $60 so that you at least break
even on costs.

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If you take yourself away from the manual work to help with the business side of things, your
own labor cost becomes overhead, which increases your overhead markup. Let’s go to example
C to demonstrate this.

Example C:

Let’s say you want to shift from billable construction work to office work instead. Your time then
shifts into an overhead cost because it isn’t going into a project with a dollar amount on it.

Your overhead costs include:$200 insurance+ $200 utility bills+ $200 office supplies+ $1,200
(your own cost of $15/hour x 20/week)= $1,800/month

Your labor costs are $2,400/month because you pay someone $15/hour for 40 hours/week.

You’d need to hire additional labor to reduce this markup or dedicate your spare 20 hours per
week back on-site.

2. By sales

Let’s say you have a full-time team that is paid the same amount every month, but they do
different amounts of billable work each month. In this case, you may want to calculate your
construction overhead by sales.

To calculate your overhead by total sales, divide your monthly overhead by your average
monthly sales. This figure is your overhead markup percentage, which you add to a project
estimate based on the cost of that project.

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Example A:

In this example, let’s say your overhead costs are $600/month ($200 insurance + $200 utility
bills + $200 office supplies). Your sales are $5,000/month. Here’s how you’d calculate your
overhead markup:

That means if Project 1 will cost you $1,000, you need to add an overhead markup of $120
($1,000 x 12%).

If you have multiple employees, your average monthly sales will increase, and your overhead
markup will decrease because you’ll be able to spread your overhead costs across more
projects.

Example B:

Let’s say your monthly costs are the same, but your average sales are $10,000/month.

For the same Project 1 with costs of $1,000, you’d need to add $60 ($1000 x 6%).

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It’s also essential to remember that your overhead cost isn’t a one-time calculation. Business
expenses can increase as well as decrease, so it’s crucial to re-calculate at least twice a year.

Calculating your construction profit

Your profit is the amount of money left over after paying for a project’s costs and overhead. This
money can be used to reward yourself or your staff, to reinvest in business growth, or to provide
a safety cushion for future losses.

Creating an appropriate profit margin for your business involves a little bit of trial and error with
your profit markup.

Note: a profit markup (also known as a profit percentage) is different from a profit margin. A
profit markup is a percentage you add to your project costs to generate a profit margin.

One way to find your target amount is to start adding a reasonable profit figure to your project
estimates that reflect your overhead, for example, $50/day. If you’re failing to win projects based
on cost, reduce this number until you become successful; if you’re winning projects, slowly
increase this figure until you get some pushback on cost.

Once you’ve found and tested the “sweet spot,” you can calculate your profit markup (i.e., the
percentage you add to your project costs to create this profit).

To calculate your profit percentage for a project, divide your profit figure by the total sum of
overhead, material, and labor costs and multiply this by 100. This is the percentage of profit you
have applied to the project cost.

Example A:

Let’s assume your costs for Project 1 are $900 ($600 labor, $240 materials, and $60 overhead),
with a profit of $100.

You can add this percentage to future project estimates to incorporate profit.

To calculate your profit margin for a project, divide your total project estimate by the total project
estimate minus the overhead, material, and labor costs. This is the percentage that the profit
represents of the overall project estimate.

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Example B:

Your Project B estimate is $1,000, with $900 in costs ($600 labor, $240 materials, and $60
overhead).

Common Mistakes in Overhead and Profit Calculation and How to Avoid

Them
Even with the right formulas and a talented team at your disposal, mistakes can and will happen
when calculating overhead and profit. Here are a few examples:

 Profit margin vs. markup. A profit markup (also known as a profit percentage) is
different from a profit margin. A profit markup is a percentage you add to your project
costs to generate a profit margin.
 Fixed and variable costs. Don’t get lazy. Not all costs are fixed, and even slight
fluctuations in equipment costs, taxes, inflation-adjust raises, and other indirect costs can
all come back to haunt you.
 Inconsistent profit tracking. It can be easy to fall out of the habit of tracking profits on
every project, but it’s a slippery slope to estimating. This estimating can then hurt you in
the long run.
 Overly complicated payments. There’s often a direct correlation between logistics
surrounding payments and their costs. Streamlining payroll, invoicing, and expenses can
help.

If you’re struggling to keep track of payments, there are tools that can help.

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Tip for success: Utilize geofencing and time tracking to clarify expenses
Figuring out how much time your team spends on certain projects can be difficult to estimate,
not to mention non-billable. However, it’s important to ensure your labor costs are accurate so
that your overhead and profit calculations are, too.

Construction time tracking software with geofencing capabilities allows you to measure labor
and improve the efficiency of your on-site teams. With auto-start and stop based on location,
project time tracking is accurate and streamlined.

There’s no need to remind your team to punch in or to have to verify hours after they’ve been
submitted.

Hubstaff uses the GPS on your crew members’ mobile phones to know when they’ve arrived at
a job site and start the timer. At the end of the day, you’ll get a daily recap of what your crew did
emailed to you. You’ll never have to chase down hours or question the time spent at a job site.

Better invoices and estimates

Finally, when you have a clear picture of exactly how long your team spent at a site, it’s easier to
invoice clients and estimate future projects.

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