How to build an overhead rate for a contractor or trades business

"We're busy but we're broke" is the most common sentence I hear from contractors and trades owners, and the cause is almost always the same. Jobs get priced on materials and labor, and the shop, trucks, insurance, and office are supposed to come out of what is left. They do not. An overhead rate puts those costs into the price of every job before you quote it, so the margin on the estimate is the margin you keep.

The same method applies to a developer with an in-house construction crew or property management arm. Without it, project returns are overstated.

Step 1: define the overhead pool

Overhead is every cost of running the operation that cannot be traced to a specific job. Pull last year's P&L and sort every expense line into one of three buckets:

• Direct cost (not overhead): materials, direct labor and its burden, subcontractors, job-specific equipment rental, permits.
• Production overhead (in the pool): shop rent and utilities, small tools, equipment depreciation and repairs, vehicles, supervision, indirect labor, production software, safety costs, general liability and property insurance.
• General and administrative (your call): owner's salary, office staff, accounting and legal, marketing. Some companies put G&A in the pool; some add it as a markup on top. Either works if you are consistent. Under a few million in revenue, one combined rate is simpler and harder to misapply.

Watch the direct labor line. If field wages are sitting in operating expenses, move them to cost of goods sold before you build the pool, or you will allocate labor to itself. Then adjust the pool for next year: known rent increases, an added truck, a planned hire. The rate is forward-looking because it prices next year's work.

Step 2: pick the allocation base

The base is the measure of activity that drives overhead. The right one is the measure where, when a job uses more of it, the company costs more to run.

For most contractors and trades businesses, direct labor hours is the answer. Do not build five departmental rates for a twelve-person company. The precision is fake and nobody will maintain it.

Step 3: do the math

Rate = overhead pool divided by expected base. Use the hours you expect to bill to jobs, not the hours you will pay for. The difference matters.

Call it $50. Had this company used paid hours (12,480), the rate would be $38.94, and every job would under-recover overhead by about $11 an hour. Using paid hours instead of productive hours is the most common reason a calculated rate does not cover the company.

Average direct wage                 $28.00
Labor burden (taxes, WC, ~24%)        6.72
Overhead rate                        50.00
                                    ------
Fully loaded cost per labor hour    $84.72

That is the number that goes into estimating. Labor quoted at $75 an hour loses money before materials, and the P&L will confirm it at year-end, too late to act.

Step 4: apply it

• Estimating. Every estimate carries labor hours times the fully loaded rate, plus materials and subs with their own markup, plus profit. Now the profit line is real profit.
• Job cost reporting. In QuickBooks, a monthly journal entry can debit an applied-overhead account in job costs and credit an offsetting account in operating expenses. That shows job profitability after overhead without moving actual overhead into cost of goods sold. Many companies apply the rate only in estimating and a job-margin report, which is fine if someone actually compares estimated to actual by job.

Step 5: true it up

At year-end, compare overhead applied (hours x rate) to actual overhead spent.

• Under-applied (actual higher than applied): the pool grew or productive hours came in below plan. Next year's rate goes up, and this year's job margins were overstated.
• Over-applied (applied higher than actual): you ran leaner or busier than planned. Margins were understated. The rate can come down, or you can hold it and keep the cushion.

Then recalculate every year: new pool, new productive hours, new rate. A rate that has not been touched in three years is wrong in a direction you cannot see.

The owner's test: add up a year of labor hours on invoices and multiply by the overhead rate. If that is less than what the company actually cost to run, you have been paying the difference out of profit, every job, all year.

Common mistakes

• Using paid hours as the base instead of productive hours
• Leaving the owner's field time out of direct labor while including the owner's salary in the pool
• Letting direct labor sit in operating expenses so it gets allocated to itself
• Building departmental rates for a company too small to track them
• Pushing actual overhead into cost of goods sold so job margin looks right and gross margin stops meaning anything
• Never recalculating

General guidance on cost allocation for management purposes, not accounting, tax, or legal advice. Overhead treatment for tax inventory costing (Section 263A and related rules) follows different requirements. Confirm with your preparer.

Common questions