Errors in allocating contract costs on the job schedule can produce some unpleasant surprises. Sometimes when financial statements are audited according to U.S. generally accepted accounting principles (GAAP), a project that seemed to be profitable can suddenly turn into a loss. In many instances, this is due to the discovery of job-related costs that were not properly allocated to the project.
Direct and Indirect Costs
The allocation of direct job costs—such as direct labor, materials, and subcontractors—is generally straightforward. The most common problem is a simple accounting oversight or failure to assign costs when the accounting department initially records them. Your final financial statements should never include any unassigned direct job costs.
Allocating indirect costs, on the other hand, can be more complicated. Published guidance from the Financial Accounting Standards Board and other professional organizations can answer most questions, but management may still need to exercise some judgment to properly allocate indirect costs.
The confusion often stems from uncertainty about whether to relate a portion of certain overhead costs to specific contracts or to consider them general and administrative expenses. Indirect costs that should be allocated to individual contracts include indirect labor that supports the construction process rather than the business in general. These can include contract supervision, tools and equipment, supplies, quality control and inspection, insurance, repairs and maintenance, and depreciation and amortization.
In many cases you also can allocate certain centralized support costs such as payroll preparation and processing, billing and collection, and bidding and estimating. On the other hand, selling costs—advertising, sales salaries, commissions, and bonuses—are not allocable to contracts.
Rational Allocation of Indirect Costs
Once you have identified indirect costs that you can allocate to projects, the next step is to rationally and systematically apportion those costs among the various contracts on the job schedule. Allocation methods are based on commonly recognized job-related metrics such as direct labor costs, direct labor hours, or a combination of direct labor and material costs.
For example, after determining what percentage of the company’s total direct labor costs a specific project incurred, you could allocate the same percentage of the company’s total supervisory or inspection costs to that project. On the other hand, depreciation and insurance costs for equipment might be allocated more rationally using machine hours as a basis. Purchasing department overhead costs might be allocated based on the number of transactions.
Choosing the appropriate basis for allocating various indirect costs is critical. GAAP requires you to use a rational and systematic approach, which is also necessary to accurately determine profit or loss and to avoid last-minute surprises on financial statements.
Note that it is also important for job estimators to fully understand these cost allocation methods and apply them when preparing bids. Underestimating indirect job costs can lead to cost overruns and lost profits, while overestimating may prevent you from winning competitive bids.
One question that sometimes causes concern on the job schedule relates to the reporting of contract losses. When you recognize that a project will result in a loss, you might think it is prudent to wait until the job is complete and the exact amount of the loss is known before recording it. GAAP rules clearly prohibit this.
You are required to recognize an impending loss as soon as it becomes evident and to report the estimated loss in its entirety during the same reporting period, regardless of when you expect the job to be complete. Any final adjustments to reflect the exact amount of the loss will be reported in a later reporting period.