Figuring profit must include equipment costs

By DAN D. SMITH
Omware

To determine true profitability of construction projects, the use of equipment must be accurately applied to jobs as the project progresses. Otherwise, estimators and managers will be fooled into thinking jobs are profitable when they are not and will allow equipment to sit idle or under utilized.

Determining work-in-progress values for construction projects also requires accurate allocation of equipment. In addition, managing equipment as a profit center will help in making good decisions about when to rent, purchase, sell and lease equipment.

Small tools

Both equipment and small tools need to be allocated to jobs as they are used to perform work, but two different methods are needed to make the allocation process manageable. For the purpose of our discussion small tools are any resource that the company owns that is not practical to track individually. This could include saws, hand tools, nail guns, barricades, etc. or even compressors, pickups or other large items that cannot be effectively tracked to one job.

For these items, it is best to create a pool of all of the expenses and to estimate the cost per hour of field labor for allocation to jobs. This is accomplished by dividing the total costs for a period by the total number of hours on jobs for the same time.

Managing equipment as a profit center helps you decide when to buy, lease or sell.

The result is an estimated cost per hour for small tools that is applied to jobs as the work progresses. Additionally, this number should be used in the estimating process to determine the estimated cost of small tools for a job once the labor requirements have been determined.

Once a number has been arrived at, a payroll overhead accrual is set up to automatically accrue the costs as payroll is done each pay period. In this way, there is no additional work to have small tools applied to projects. Periodically, the accrual should be reviewed to see if it is higher or lower that the actual costs for small tools and adjusted as needed.

The effect on the general ledger is that the cost of small tools which is normally posted to overhead is offset by the accrual to jobs giving the additional benefit that overhead is more clearly defined.

Equipment

Larger pieces of equipment that can be tracked to individual jobs should be allocated separately by establishing a tracking and allocation method that is appropriate to the piece of equipment. For equipment like a backhoe or grader, the best allocation system is usually the hours of use. A job shack is best allocated by days or weeks since it will not be moved often.

The method of allocation must be easy for the company to accurately maintain without adding too much additional overhead cost, so don't get carried away with too much detail!

Once the method of allocation has been determined for a piece of equipment, the next step is to calculate the cost recovery rate for that method. This is done be adding up all of the estimated costs for a period of time in the future and dividing by the estimated usage for the same period to arrive at a cost for the allocation method.

Ownership costs

The costs of equipment normally involve ownership and operating costs, each of which need to be calculated differently. Ownership costs include expenses like real market depreciation, taxes, insurance, licenses, major overhaul and cost of capital which are present whether the equipment is used or not. It is important to note that book depreciation is not used in this formula and is replaced by resource consumption, which is an estimate of the market value lost during the period of ownership.

To arrive at the total cost of ownership, estimated costs for a future time period are added together and then divided by the estimated use for the same period. The result is an hourly, daily or weekly amount depending on the method of tracking that was determined above.

Operating costs

The costs of operation, on the other hand, only accrue when the equipment is actually used. These costs are calculated for the method of tracking (hours/days/weeks) and totaled to arrive at the operating costs per unit of time. Operation costs include fuel, oil, maintenance, tires, and other consumables that are related directly to usage.

The distinction between operated and stand-by time is that operated time is hours of actual use and standby is the hours the equipment is on the job, but not in use. It may be necessary to track these two types of use for certain pieces of equipment, especially when a contract allows charging for standby time separately from operated time.

The cost of operated time is determined by adding the ownership costs to the operating costs while the cost of idle time has only the ownership costs included. Together, these rates represent the cost recovery rates for the equipment and can be used to estimate jobs as well as allocate costs to jobs.

The allocation process

Once the cost recovery rates for equipment have been determined, the process of allocating the equipment to jobs is really quite simple. Field reporting is used to determine the hours, days, or weeks of use and this information is then entered into the accounting system where it will be posted to job costs and general ledger.

The result of this entry is that the job costs will reflect the cost of the equipment and the equipment expenses in the general ledger will be offset with the cost to jobs applied to direct expense. In addition to having accurate job costs, the equipment profit center will reflect the true cost of owning and operating equipment.

Whether you are working as a remodeler or a large excavating contractor, accurately allocating the cost for hand tools and equipment is an important part of company management. While the remodeler will want a super simple method of cost allocation for hand tools, the general engineering contractor will need to keep accurate records of the use of large equipment on jobs in order to evaluate profitability accurately.

This information also forms the basis for estimating of future jobs and needs to be periodically reviewed for accuracy.

Fortunately, a few of the construction accounting systems available today will automate both small tool and equipment allocation by linking small tool use to payroll hours and allowing equipment to be posted along with payroll. Contractors should consider a construction management software system over a generic accounting system when automating their accounting.

Copyright © 1998 Seattle Daily Journal of Commerce.