The Kentucky CPA Journal

Feature

Rethinking overhead: Improving indirect cost allocation for construction contractors

Issue 2
July 30, 2025

By Collin Temple, CPA, CCIFP

In the world of construction accounting, the allocation of indirect costs, or overhead, continues to be one of the most consequential and misunderstood areas in both financial reporting and job costing. For CPAs working with contractors, a clear grasp of indirect cost allocation is not just a technical exercise but a strategic opportunity to enhance financial accuracy, improve competitiveness, and support better business decisions.

Overhead encompasses those costs that cannot be directly attributed to a single construction project but are necessary to keep the business running. Examples include project management salaries, office rent, equipment depreciation, insurance, utilities, and supervisory labor. How these costs are allocated across jobs can have a profound effect on job profitability reporting, work-in-progress (WIP) schedules, and ultimately the contractor’s financial statements.

Under generally accepted accounting principles (GAAP), contractors using the percentage-of-completion method are expected to include a reasonable allocation of indirect costs in their contract accounting. This is emphasized in the AICPA Audit and Accounting Guide for Construction Contractors and reinforced under ASC Topic 606, which requires that costs to fulfill a contract be capitalized and matched with contract revenue when certain criteria are met.

Despite this guidance, indirect costs are often applied inconsistently or not at all. Smaller contractors may rely on simplified methods that fail to reflect the true cost structure of the business. Some firms allocate indirect costs as a flat percentage based on direct labor or materials, without revisiting the underlying assumptions as the business evolves. Others apply indirect cost rates inconsistently across contracts, distorting gross profit margins and impairing the usefulness of WIP schedules.

The consequences of poor overhead allocation are not just academic. Underallocated overhead can lead to overstated job profits, which may mislead sureties, lenders, or prospective buyers. Conversely, overallocating overhead can understate job performance, leading to internal decision-making challenges and missed growth opportunities. In both cases, inaccurate allocation reduces the credibility of the financial statements.

CPA’s have an important role in helping construction clients refine their overhead allocation methods. A good starting point is to review the company’s current pool of indirect costs and ensure that only appropriate items are included. The next step is to evaluate the allocation base. Common bases include direct labor hours, total direct costs, or machine hours. Each with strengths and weaknesses depending on the contractor’s operating model.

Once the appropriate base is selected, it’s important to calculate and apply the rate consistently across all active jobs. This ensures that the WIP schedule reflects a uniform cost structure, which enhances the reliability of over/under billings, backlog analysis, and projected completion costs. It also improves comparability across projects and time periods.

For companies that perform both bid work and service work, it may be appropriate to apply different overhead rates to each category. The same may apply to divisions that have materially different operating characteristics, such as electrical vs. heavy civil. In these cases, CPA’s should help clients develop multiple cost pools and document the rationale behind the allocation strategy.

Technology can also play a supporting role. Many modern job costing systems and construction ERP’s offer the ability to automate indirect cost allocations based on customizable rules. CPA’s can assist clients in setting up and testing these systems, ensuring they align with GAAP and reporting objectives.

Ultimately, the goal of improved indirect cost allocation is better insight and better decisions. A well-reasoned and consistently applied overhead strategy not only improves the quality of financial reporting but also provides management with a clearer view of which jobs are truly performing. For CPA’s serving the construction industry, this is an area where technical knowledge and practical experience converge to deliver lasting value.

About the author: Collin Temple, CPA, CCIFP is an audit manager at Monroe Shine & Co., Inc. in New Albany, Indiana. Temple serves on the Society’s Accounting and Auditing Committee.