Profit margins have been historically razor-thin in the construction, architecture, and engineering (AEC) industry.
Net margins for the engineering/construction segment, according to data reported by NYU’s Stern School of Business, are a meager 2.16%.
Put this into context with other industries—but particularly known cash-rich industries—and you begin to realize why construction companies face a unique challenge when trying to capture profitability. For example, regional banks enjoy a whopping 30.31% net profit margin. The oil & gas industry, particularly known for being cash-rich (e.g., see coverage in The Guardian, The New Yorker), enjoys a 26.01% net profit margin. The semiconductor industry, a booming segment (see: McKinney article discussing this trillion-dollar industry), enjoys a 22.74% net profit margin. Tobacco, which has had a complicated history (and some particularly morally questionable ad campaigns), enjoys a 23.46% net profit margin. Even publishing/newspapers, a category that has been almost synonymous with layoffs (see: PEW Research report), sees a slightly higher net profit of 2.82%.
What’s more, construction is plagued with other concerns (e.g., rising construction costs, high interest rates, and persistent labor shortages).
A Forbes forecast for the industry, what’s worse, predicts non-residential construction to shrink as the economy is expected to enter what Moody’s is describing as a “slowcession” (Moody’s via CNN Business), combined with those high interest rates we mentioned above. Senior Forbes contributor Bill Conerly summarizes the situation, noting, “The decline won’t be devastating, but it will be significant.”
With all this doom and gloom out of the way, one positive outlook we may offer is to look at lean practices, and how they have transformed the manufacturing industry. There changes have, nonetheless, been difficult-to-implement, long-term infrastructural process changes. However, the adoption of lean manufacturing principles in manufacturing has allowed many companies to increase their margins. These practices helped Apple, on the brink of bankruptcy, reshape and become one of the most valuable brands. The same challenges exist with implementing lean construction, the big infrastructural process changes that will be hard to implement but poised to drive the industry forward.
This all starts with lowering construction overhead, a key metric owners will need to watch closely in order to keep finances in the black. In a 2019 pricing & spending update, the Bureau of Labor Statistics (BLS) stressed the importance of a contractor’s overhead, inextricably linked to profits: “contractors’ overhead and profit percentages are of interest because they can highlight certain market conditions that cannot be isolated by looking only at changes in price.”
While the term overhead should be in the lexicon of any business owner—from retail shop owners to ecommerce entrepreneurs—construction owners in particular will need to manage it even closer to stay financially solvent.
In this article, we’ll break down this important concept and also give some tips for managing construction overhead to maximize profits in construction projects.
Overhead Definition: Explaining What Overheads Costs Are in Business
Merriam-Webster defines “overhead” (noun: See definition 3) as “business expenses (such as rent, insurance, or heating) not chargeable to a particular part of the work or product.
Shopify, a popular ecommerce platform for online stores and retail point-of-sale systems, defines the term similarly: “expenses and operating costs” which are “associated with running a business [and that] can’t be linked to creating or producing a product or service.” These “overhead costs,” they explain, are the kinds of “expenses the business incurs to stay in business, regardless of its success level.” These expenses, they explain, are representative of “all of the costs on the company’s income statement except for those that are directly related to manufacturing or selling a product, or providing a service.”
Examples Shopify gives for overhead costs include:
- Salaries that aren’t job- or product-specific
- Office equipment, such as computers or telephones
- Office supplies
Finally, Investopedia offers a few key “takeaways” relevant to overheads:
- Can be fixed, variable, or a hybrid of both.
- Different categories of overhead exist, such as administrative overhead, which includes costs related to managing a business.
- The income statement reports overhead expenses
Types of Overhead
As Investopedia notes, there are typically three main types of overhead:
- Fixed Overhead: As the “fixed” nomenclature suggests, these costs remain set and are to be expected “for a long period of time and do not change as business activity ebbs and flows” (i.e., persistent whether business is booming or when growth is slowed). Examples that Investopedia offers include rent, depreciation, insurance premiums, office personnel salaries, and licensing costs.
- Variable Overhead: Similarly, as the “variable” nomenclature suggests, these costs represent those incurred as business activity fluctuates—as business activity increases, variable overhead increases, and vice versa. Examples Investopedia offers include office equipment, shipping and mailing costs, marketing, legal expenses, and maintenance.
- Semi-variable Overhead: As Investopedia notes, are a “combination of fixed and variable overhead where some costs are incurred regardless of business activity but may also increase if business activity grows.” Examples they offer include commissions and utility costs—whereby utilities, for example, a base amount is charged, and the remainder of the charges are calculated based on usage.
Furthermore, other categories of overhead may include:
- Operational categories like the general and “administrative overhead” (i.e., overhead related to the general management and administration of a company, such as the need for accountants, bookkeeping, human resources, payroll, receptionists, scheduling, etc.).
- Selling overhead, activities involved in marketing and selling goods of services (e.g., printed materials and television commercials, as well as the commissions of sales personnel).
- Research overhead, Lisa A. Boyce of the University of Surrey explains in an article for The Journal of Research Administration, represent “expenses necessary to support research, which may not be attributed to a specific research project,” such as “costs to support the research environment, including administrative and facilities costs.” Examples may include academic support (e.g., research and teaching assistance), library and IT support, etc.
- Maintenance overhead, such as upkeep (changing carpets, lightbulbs, etc.), repairs to HVAC systems, plumbing, computer equipment, etc.
- Manufacturing overhead, such as rent and taxes, salary and cost control, and manufacturing equipment maintenance and repair.
- Transportation overhead, described by Bench Accounting as, ““the cost of travel not directly related to your product or service (e.g., gas mileage for commuting to work, travel to conferences, or meetings).”
Construction Overhead Definition: What Does Overhead Mean in Construction?
Based on what we outlined to be generally true across the gamut of business applications, a Construction Overhead Definition might read as such: Business and operating costs associated with running a construction or contracting business and incurred to keep these businesses operational, and not tied to any one specific project.
Construction Overhead Examples: What Are the Types of Overhead in Construction?
So, what are overhead costs in construction? The types of overhead we discussed above are equally applicable to construction.
Typical overhead costs in construction you may encounter include:
- Accounting, subscription costs for project management software, equipment purchasing and preventive maintenance, etc.
Pro Tip: Managing construction inventory, which we’ll discuss below, is an important part of keeping overhead costs down. But did you know Milwaukee Tool offers a free inventory app? Learn more about using the ONE-KEY™ inventory app to decrease construction downtime and increase productivity.
- Variable construction overhead costs may include advertising your business with fliers, business cards for your team; digital marketing like hiring an agency to redesign your company’s website, paid promotion on a relevant construction podcast; signage at a construction trade show or conference; or upgrading your fleet vehicles or equipment inventory to the newest power tools; etc.
- Semi-variable construction overhead costs, meanwhile, include equipment maintenance and purchasing.
Pro Tip #2: You can better manage your equipment maintenance by updating exhaustive service records with virtually limitless documentation in One-Key and can even add tool maintenance reminders at the frequency of your choosing, to ensure you’ll remember to take care of that preventive maintenance and avoid possible breakdowns.
How to Calculate Overhead Costs in Construction Projects
Common questions contractors frequently want to know related to overhead are:
- How to calculate overhead rate in construction? Overhead in construction is typically calculated by dividing direct costs by indirect costs, then multiplying that by 100.
Direct costs ÷ Indirect Costs × 100
- What is a good overhead percentage in construction? 10% overhead with 10% is considered a good rule of thumb, according to FreshBooks, an accounting SaaS provider. While These profit and overhead percentages may serve as a good industry benchmark, they also suggest (and we agree) it’s a good idea to do some research to determine what the standard may be for businesses within your region, as these percentages may vary geographically.
The above sentiment about how calculating overhead and profit percentages may vary geographically is also echoed in advice by the BLS:
Some contractors charge different overhead and profit percentages on the cost of materials versus the cost of installation, while others charge a single rate based on the total cost. Still others report separate compounded percentages broken out by overhead first and then profit. These effective markups are then totaled, using the same weights and index structure as the published nonresidential building construction PPIs.
7 Ways to Manage Construction Overhead & Maximize Profits
You now know what construction overhead is, as well as how to calculate costs in construction projects.
Here are 7 ways to manage construction overhead and maximize profits:
- Construction Forecasting
- Construction Job Costing: Free Rental Rates Tool for Calculating & Managing Overhead
- Project Management & Collaboration
- Construction Project Digitization
- Lean Construction Methods
- Design-Build Methods
- Sustainable Construction Materials
1. Construction Forecasting
As previously reported, only 31% of all projects come within 10% of the budget (KPMG via One-Key connectivity blog). What’s worse, as previously reported, construction overruns are experienced in 9 out of 10 (International Journal of Innovation, Management and Technology via One-Key blog).
Construction forecasting plays an important role in keeping overhead down.
Example methods to project accurate construction forecast include:
2. Construction Job Costing: Free Rental Rates Tool for Calculating & Managing Overhead in One-Key App
One process in the toolkit of project managers at large construction companies Construction Job Costing.
What is construction job costing? It’s a process that helps you stay on top of associated costs (labor, materials, and importantly overhead) to, at any given time, give stakeholders a complete picture of a project cost breakdown.
We recently released a job costing, construction overhead management tool for inventory and tool managers, free to use in the One-Key app.
Some of the features helping you manage overhead:
- You can add rate sheets, either manually or via “smart sheet,” and apply daily and/or weekly rental rates outlined in these rate sheets for individual tools or entire kits full of inventory you’re sending to the job. This will help you calculate the cost accrued for each day your inventory is in the field, useful to keep these equipment-related project costs down.
- You can also create job costing reports and chronicle these reports, an added feature to increase visibility and create a culture of accountability.
3. Project Management & Collaboration
A 2016 PMI survey reported that for every $1 billion invested in the United States, $122 million was wasted due to lacking project performance. A good construction project management strategy can help empower work to progress smoothly—project managers will manage oversee full-scale projects and (importantly) balance budgets, scheduling timeline targets and scope costs; oversee quality and ensure proper compliances are met; etc.
Using collaboration tools (e.g., project management tools like Procore); productivity tools like Microsoft Office 365 and Google Drive; and messaging platforms like Slack or Microsoft Teams can help ensure teams across your organization are communicating and collaborating smoothly and any project issues are quickly addressed.
As an aside, the One-Key app offers the ability to import contacts from your address book, and streamline communication with these collaborators by allowing you to call, text, or email the people you need to, right from the app—so you can be productive and communicative right from your workflow without skipping a beat. What’s more, our multi-user admin allows you to empower your tool team to collaborate with custom permissioning for added organization security.
Want to take your project management game to the next level? Globally, 85% of CEOs believe that AI will “significantly” impact their business in the next five years. 63% agree or strongly agree that AI will make a bigger difference to business than the advent of the internet (Source: PWC global CEO survey).
The world’s your oyster!
4. Construction Project Digitization
A staggering FMI report highlights a key statistic about project data: 95.5% of all data captured goes unused in the E&C industry.
Further, a joint FMI/Autodesk report found only 36% of firms have implemented a process for identifying bad data and repairing it. The same survey found that 14% of all construction rework may have been caused by bad data creating $88.69 billion in avoidable rework globally.
One thing remains clear: Digitizing processes remains crucially important to chipping away at the cumbersome, inefficient processes that kill productivity and drive overruns—how these robust and all-encompassing these digital processes are, importantly, is the ticket because data in a vacuum isn’t particularly useful.
As an example to reinforce this theme, 79% of contractors did report using software to capture data and manage information, an Autodesk/Dodge Data & Analytics survey found—however, the same survey found 41% of contractors to believe that non-standardized data input leads to inconsistent, inaccurate, incomplete, and unusable data.
Example data integrations that may prove critical to your operations:
It’s also worth noting that the earlier FMI/Autodesk report we mentioned above found that 75% of respondents stated an increasing need for rapid decision-making in the field. Consider how useful in-the-field audits, equipment location troubleshooting, and tool lockout may be to prevent theft and keep projects running smoothly.
Pro Tip: You may even consider hiring a full-time construction technologist to help your organization undertake a digital transformation.
5. Lean Construction Methods
Lean construction incorporates offsite construction (see: prefab construction, modular construction) and in some cases 3D printing to offload as much of the upfront assembly, with these components assembled onsite later. Lean construction can help skirt inclement weather conditions and keep project schedules in line while also reducing rework.
6. Design-Build Methods
Design-build construction methods are growing in popularity, with a 2018 survey reporting 58% of owners had stated they’d used or planned to use design-build.
These processes, as the name suggests, brings design inhouse to save significantly on time it takes to build, and in many cases can cut down on fees. What’s more, it can deliver projects 102% faster than the traditional approach (source: DBIA).
When paired with other innovative approaches like Building Information Modeling (BIM), which can streamline QA, owners can potentially maximize the quality and quantity of projects they deliver.
7. Sustainable Construction Materials
Sustainable construction, as previously reported by our friend Rose from Renovated, and sustainable building materials can be an economical alternative (both in terms of their environmentally friendliness and their lower cost in comparison to some materials) to materials like lumber that has become expensive to ship.
The green & renewable energy sector has also been an industry that has seen and new jobs (see: solar panel installer and wind turbine technician) and a strong net profit margin 17.77% (as seen in the above-mentioned NYU Stern breakdown).
Construction is an industry that has seen historically razor-thin profit margins, where overhead is even more critical to control.
“If contractors are able to increase their overhead and profit percentages,” the BLS notes,
“it shows that they are confident either that demand is sufficient or that competition is low enough to support the higher markup.”
The above tips should help you manage your construction overhead to drive better profits in 2023!