Best Practices – Overhead Costs – What Constitutes Overhead Costs and Why Your Projects Should Not Be Paying Them.

By now everyone in construction knows to ask contractors to quote their overhead and profit (OH&P) as a separate line item.  This request is so common that most contractors naturally provide their overhead and profit separately without asking.

Despite nearly universal alignment on quoting these costs separately, there still seems to be little to no consistency on what costs should be included in OH&P.

I frequently see Contractors charging costs to a project that should be part of their overhead.  I also see Clients treating costs that belong in overhead as separate reimbursable expenses.

Both practices are wrong and create an undue burden on projects while reinforcing incorrect behaviors.

I think the concept of profit is quite clear, so for this article we will focus on what costs belong in overhead.

Overhead

Determining what costs should be considered overhead, you simply need to think about what costs are required for the business to operate.  To simplify the discussion, I will group each cost into a cost category.

Liability Insurance

In order to operate, most jurisdictions require a minimum amount of liability insurance.  This is a pre-requisite for issuing a business license.  As such, liability insurance definitely belongs in overhead and should not be treated as an expense on a project.

Now, there are circumstances where the amount of liability insurance carried by the Contractor is less than the amount the Owner requires.  Insurance levels should be considered a form of litmus test that tells us whether the Vendor we are working with is right for the work.

Owner’s do need to be careful about what they ask for.  The amount of insurance you require should be commensurate with the cost of the work.  If there is any doubt whether the insurance levels are correct, you should ask your insurance provider.

Once the amount of insurance required has been confirmed, if the amount of insurance carried by the Contractor is less than the project requires then the contractor should be consider under-insured to do the work.  If the contractor is able to secure more insurance, then they certainly can in order to meet the requirement.  This does not change the fact that the cost of liability insurance still belongs in overhead.  However, I often see Owner’s accepting project charges for added liability insurance.

If the Contractor is under-insured for the project, we then need to consider whether we have the right size Contractor.  We don’t want to award work to a contractor that is too small for a project nor do we want to hire a firm that is too big for a project.  If your Contractor is not carrying enough insurance for your project this is a sign that you should not hire them.  This does not mean that you must reimburse them for carrying the proper amount of liability insurance.

Operations Staff

Most Construction Companies require administrators, receptionists, accountants, clerks, IT staff, and other operations staff to run their business.   These home office employees perform essential functions for the business.  They are typically not project specific and when they do touch a project, the time they put into the project is either blended in with other projects or it is less than 30 minutes a week.

There most definitely is time that a contractor’s operations staff will spend on specific projects.  This time typically has to do with creating invoices, procuring services, managing contracts, and other duties associated with the project.  This time is no different than the time any other type of company spends on similar tasks, and just like other types of companies, these costs are all part of the business overhead.

If there is a specific requirement that causes one of these staff members (or someone performing a similar function) to be dedicated to a project then that specific case should be carried as a project cost, but it should be noted that this is quite rare.  In order for this type of circumstance to be present the staff member must be dedicated to the project and generally speaking they should be located at the project site.  Unless those conditions are met, staff such as; clerks, procurement personnel, and accountants should be considered overhead costs.

I have often seen Clerks who’s job is to prepare invoices charged as part of the project team.  No other business would charge a Client for a clerk to prepare the very same invoice they must then pay.  Why would anyone accept that in construction?

Management Staff

Another cost that I often see passed on to a project is the cost of management.  This tends to happen more with Architect’s than with Contractors, but in either case the cost is misplaced.

Regardless of the business you are in, every company has management staff that is responsible for managing the performance of their staff.  These managers may oversee; the quality of the work, correct bad behaviors, manage staffing levels, approve timesheets, review invoices, and even make changes to improve delivery.  For Architects and Contractors these tasks are no different.

Every project must have staff supervision which may require site visits or time invested in reviewing the staff’s work.  Think of this time as quality control.  This is not optional time.  This is not time specifically requested by a Client.  This is time you MUST provide in order to ensure that your staff is producing the right results.  In other words, this time is part of the Vendor’s overhead costs and should not be charged to a project.

There are times (especially with smaller companies) where the Owner of the Company is an integral part of the delivery team.  When this happens the Owner needs to properly differentiate between the time they are spending on managing and the time they are spending on delivery.  This can be difficult to discern, but it is a burden small businesses must bear.

When we are soliciting a quote for a project, it is important to be clear that we should not be paying a premium for staff supervision.  I often see quotations developed with time included for high cost Principals.  These Principals generally do not spend much time on the project and simply inflate the cost of the work.  That’s not to say we don’t want them supervising the work.  There is an expectation that they are supervising their staff, however, the cost of the time they spend on the project needs to be carried as overhead costs not as a direct charge to the project.

Other overhead charges

There are a number of other business operations charges that both Architects and Contractor must cover in their overhead costs.  It is rare for any of these to be passed along to a project, but for the sake of rounding out this discussion, I’ll list them here.

Home Office Real Estate and Utility costs

The cost of rent for offices space, utility charges for electricity, water, gas, and internet, and maintenance expenses associated with the Contractor’s home office are all examples of costs that belong in overhead.  Occasionally, I see contractors charging rent charges for storing or receiving equipment or materials.  This can be allowed only if the Owner has specifically requested that the Contractor store something and if the items being stored are specifically segregated from other items that do not belong to the Owner.

Statutory Insurances

Insurances such as automotive insurance and workers compensation insurance are both insurances required by state and local governments.  These insurances are similar to liability insurance in that they are required and should be provided regardless of whether the business has work or not.  These costs belong in overhead and should not be charged to a specific project.

Licenses

The cost of business or professional licenses are clearly overhead costs.  I cannot recall ever seeing charges for these costs being transferred to a project, but if you are ever asked to pay a fee for business or professional licenses you should refuse those charges.

Interest on capital

There are many businesses that run on borrowed money.  This is often the case with service businesses where the work is often performed well ahead of being paid.  The reality is that while you (or your Company) may have 30 days to process a payment, many trade and equipment vendors demand payment on delivery.  We have documented this on this blog quite a bit, so it should be no surprise that in order to operate many of these businesses rely on loans to manage cash-flow.  That means that businesses that rely on loans also incur interest charges.  This is why smaller businesses may charge late fees for late payment.  They are not making money on the late fee, they are simply recovering the cost of interest they incurred.  That said, unless your payment was later than what was agreed in your contract, the cost of capital should be carried in overhead and should not be applied to a project.

Software and Computer Charges

Back in the 1990’s when computers were new, it was common to see computer charges being added to project costs.  Today, everything happens on computers and businesses simply cannot operate without them.  There was a time when Architects charged for AutoCAD licenses and CADD stations.  These are now considered required tools for doing business and very rarely do I see those charges added to a project.  The new CADD technology now is BIM modeling and I still see some Architects adding charges for BIM stations.  I find these to be bad business practice that will eventually disappear.  While many Architects stubbornly remain steadfast, refusing to remove these costs, they do so at the detriment of their own success.  If you receive a quote that includes charges for software, challenge those costs.  Unless you specifically ask a Vendor to use a particular piece of software, the Vendor should pay for all tools needed to perform the work as part of overhead.

Closing

There are a lot of overhead costs in Running a business.  Vendors are entitled to recover these costs, but they should distribute these costs evenly across all Clients as overhead.  They should not target specific Client or projects to recover expenses that are a requirement of doing business.

In order to have enough pricing detail to sort through these items, you will have to request it in your solicitation.  Most projects are quoted as a fixed price which will include all of the above costs.  You won’t need to worry about all of this if you are soliciting a fixed price under a competitive (3 or more Vendors) quote.  However, you do want to be wary of all of this if you are using an hourly rate or time and material contract.  Also if you see any of the above quoted as an extra cost separate from the fixed price you will want to negotiate that in as overhead.

What about you?  What other costs have you successfully negotiated into overhead?  Did I miss any costs that you frequently see?  Tell me your stories.

Thanks for reading.  If you enjoyed this content, please feel free to browse my previous articles and please like, share, comment, and subscribe.  This helps promote my content and is greatly appreciated.

 

 

 

 

 

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