Allocating Costs in Your Cost-Plus Construction Contract

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We know that leveraging a cost-plus pricing model can help builders and remodelers manage risk – but only if done properly. Part one of our Ultimate Guide to Cost-Plus Pricing explored the first step in launching a cost-plus model: choosing the markup. But that’s only half the battle! To effectively profit from this pricing model, you have to know which costs to mark-up. It sounds simple, but not all costs are as easy to find as the ones on your subcontractors’ invoice or the home improvement retailer receipt. It’s possible your company is forgetting a few hidden cost buckets (and are giving them away to your customers for free).

Let’s explore three of the most common expenses that construction companies forget to include in their cost-plus model and share some ways to make sure you’re getting paid for them:

  1. Self-Performed Labor
  2. Indirect Costs and Overhead
  3. Change Orders
 

Don’t forget your labor. It’s easy to miss because it’s not on an invoice!

We believe all labor costs are treated equal, and the work that you and your team do on the job site needs to be accurately calculated and charged to the customer. This type of “self-performed labor” can include specific project workstreams (like plumbing or electrical, which you probably won’t forget to include) but also includes more general tasks like job supervision, project management, cleanup, and light carpentry.

These general tasks can sometimes feel like “just part of the job,” especially for a hard-working employee. Maybe they stop by a job site at the end of the day and clean a messy workstation, or maybe the framing is taking longer than expected, so they chip-in to hammer the last nail before the sun sets. That time, no matter how long, should get charged to your customers. If you’re paying your employees to be there, your customer should be paying you!

The best way to manage and allocate these costs is to have your employees keep accurate records of how they spend their time. Once you know how many hours they spend on this self-performed labor, you can multiply those hours by an hourly rate to find out how much cost should get marked-up to your customers.

 

Allocate ALL of your company’s costs, even if not explicitly related to a project. You need them to be successful, and the customer needs you to be successful

Indirect and overhead costs are costs that are critical to helping you run your business, but aren’t directly related to homebuilding or remodeling. The most common indirect and overhead costs are things like rent, marketing, insurance, and the salaries of your administrative team. These costs can add up quickly, so it’s important that you track them and charge them to your customers.

Allocating indirect and overhead costs across jobs can be tricky because they aren’t directly related to a specific project. Builders can take a few different approaches to allocate these costs:

Time: A common method is to allocate overhead costs based on the time spent on each project. This method assumes that the longer the project takes, the more overhead costs it will generate. Imagine that last year you spent $120K on administrative employees and completed 2 builds, one that took 3 months and one that took 9 months (we hope you had more than 2!). Using the time method, you would divide the $120K by 12 months of work and decide that each month costs $10K in overhead. If your next project will take you 5 months, you can charge them $50K of overhead, plus your markup!

Square footage: Another method involves allocating overhead costs based on the square footage of the project. This method assumes that the larger the project, the more overhead costs it will generate. To use this approach, you could consider last year’s spend again ($120K) and last year’s builds (2 homes, one 2,000 square feet and one 4,000 square feet). Together, they imply that you spent $20.00 of overhead per square foot ($120K divided by 6,000 square total feet). For your next project budget, you could estimate the overhead cost at $20 x the estimated size of the project.

Direct labor or materials: The third method is to allocate overhead costs based on the direct labor cost or the direct materials cost of each project. This method assumes that the more labor or materials required for a project, the more overhead costs it will generate. Similar to the square footage approach, you can look at past projects and do a quick calculation: how much was our overhead last year, and how much did we spend on direct materials? You can then use that ratio to estimate costs on future projects.

It’s important to note that there is no one-size-fits-all model for allocating overhead costs. You should choose the method that you think is most appropriate for your business and fairly allocates costs to your customers, but make sure you keep a detailed record of your calculations in case they ask!

 

Things change – track them carefully

If there’s one thing we know about budgets, it’s that they change! Maybe your customer decides they want to move that closet after you installed it, or maybe they just couldn’t resist the temptation to splurge on the marble countertop instead of the laminate.

To make sure you are paid for these changes, you need to ensure that your construction contracts define the type of changes that are acceptable, including changes in scope (the closet) and changes in price (the countertop). If your contract protects you from these extra costs, you can include the direct materials and labor associated with change orders in your pricing model. And don’t forget the time you spend on change order administration! We know they are challenging to keep track of and manage.

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Need help getting your bookkeeping in order using your existing tech stack? Monthend provides bookkeeping, accounting, tax, and construction technology consulting services for construction businesses that want to leverage accounting and technology to become more profitable. Schedule a free consult call with Monthend today!

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