Timely and accurate cost accounting can assist in managing projects, costs and cash flow.
By Jake Dopson, assurance manager, CPA, CCIFP
One of the most critical accounting functions that construction contractors must consider is the appropriate processes and methodologies used in accounting for costs of construction. Not only do contractors have to consider recording such costs accurately within their financial records, they also must determine a reasonable and consistent methodology to allocate these costs to individual contracts.
Costs of construction can generally be segregated into two basic categories: direct costs and indirect costs. Direct costs are defined as construction-related costs incurred that can be attributed specifically to a particular contract. Examples of direct costs include materials, labor, and subcontracts. Indirect costs are defined as costs incurred that cannot necessarily be attributed to a specific contract, but are still construction-type costs in nature and must be accounted for accordingly. Examples of indirect costs include depreciation, supplies, repairs and maintenance, and insurance. Costs that do not meet the criteria for of being direct or indirect construction costs will generally fall into the general and administrative cost category for the period in which the cost was incurred.
Direct costs of construction are relatively simple to account for, as these costs generally pertain to a specific construction contract. For example, a contractor should have a process in place within its labor and payroll system for employees to enter the amount of time spent working on any particular contract. Using this information, it is relatively easy to then allocate the labor costs generated through the payroll system to each specific contract that those costs applied to.
Identifying and allocating indirect costs is generally much more complex than allocating direct costs. Quantifying and allocating indirect costs involves management making a determination of the kinds of costs that should be treated as indirect construction costs, and then developing a systematic, rational, and consistent methodology of allocating these costs to individual contracts. In determining which kinds of costs should be treated as indirect costs of construction, management should consider whether the natures of costs under consideration are identifiable and related to construction-type activities.
Once indirect costs have been identified, these costs should be included in an overhead pool to be allocated to the construction costs of individual contracts. Accounting principles generally accepted in the United States (GAAP) allow for a variety of methods for allocating overhead costs among contracts. Examples of such methods include labor hours, labor costs, or materials costs. In general, a contractor should choose a methodology that is consistent with the type of construction activity and costs incurred. For example, a contractor with contracts that are highly labor intensive should most likely allocate indirect costs to contracts based on the direct labor cost activity of each contract as a percentage of total direct labor cost.
By understanding the components of the costs incurred in performing against its contracts, contractors will be able to make informed determinations of how to account for, and allocate these costs. This will inevitably lead to better management of contracts in process, and will also provide contractors with the information needed to submit accurate bids on future contracts.
For more information on how your company can achieve better results, contact the team at Pulakos CPAs – where Performance Matters™!