Welcome back to our “Ask an Industry Pro” series! In episode 4, Chris answers your questions regarding the different types of construction business expenses, how they affect your company’s cash flow, and how to ensure the profitability of your projects. You can also find a full transcript of the video below.
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Welcome to episode #4 of Ask an Industry Pro. My name is Chris Jurin and today what we were going to be looking at is understanding expenses. We are going to bridge over into the accounting part and finance part of the construction industry.
The Different Types of Expenses
So, what we’re really going to deep dive into is just understanding expenses. So, what we’re going to look at is what’s the difference between direct expenses, indirect expenses, and overhead expenses. And then we’ll take a look at some tips on how to handle those expenses on your financial statements. So, if you’re ready, let’s explore some of the options. But before we jump in too quickly here, what I just need to tell everybody is that I am not your financial advisor. What we’re talking about here is purely educational and we strongly recommend that you work with a quality accountant who can help answer your questions and develop some solutions for your unique situations. I’m not your fiduciary, so you need to take a look at this and talk with an accountant who can look at your books and who understands your business.
What is An Expense?
OK, so the first thing we’re going to take a look at here is what is an expense? The first point here is expenses in the construction industry are costs that are associated with completing your projects, your jobs. They are the costs associated with running your departments. If you’ve got different departments within your company. Now if it’s just yourself, maybe you might have one crew. Chances are you don’t have departments. But if you start to grow, you start to split, you start to have maybe a service department and a construction department, then you start to look at those expenses. How they relate to how those departments operate. And then you have expenses just for operating the entire company.
So, some examples of this are materials. They’re the labor it takes to get not only the projects done, but to be able to run the business. Taxes associated with running the company, your insurance coverages and advertising and marketing expenses.
Direct Expenses vs. Indirect Expenses vs. Overhead
All right, so what we’re going to look at next is how you break up these expenses. There are three categories of them. They are direct expenses, indirect expenses, and overhead expenses. So, the first one we’re going to look at here is what is a direct expense?
Well, direct expenses are those costs that are directly related or traceable to a specific job. So, it’s the labor on the site. Is someone working on a specific project? The materials associated with that job. Did you run out to the supply house to pick up something, a box of screws? A roll of coil? That would be associated back to that job. And then equipment rentals. Did someone rent a piece of equipment? Did you get a trackhoe for a job? Did you get a floor scrubber? Whatever you did that would be associated with that job, and that is a direct expense to that job.
Remember an important point here is you can be as picky as you want to be. Whether you want to break down a box of 500 screws and you use 300, maybe you expense the whole thing to that job. Depends on whether or not you hold an inventory. So, the important point here at the bottom is to remember that it costs money to gather information, and if you’re not going to use the information, you might want to second guess whether or not you really should be spending the money and the time to be able to gather that info and that intel.
Alright, next we’re going to look at what is an indirect expense. These are expenses that are typically purchased for a department, but may have a useful life beyond the current project. So, if you have a tool, if you purchase a tool but the tool is used in more than one project, it can be an indirect expense. So, let’s say you buy an air gun. You buy a miter saw. You’re buying them for that department, but the tool is going to outlast that job. Vehicle expenses. If you’ve got trucks in your fleet that you’ve bought for a specific division within a company, they’re indirect expenses. Labor, do you employ a project superintendent or a project manager who may have more than one job going on at a time? They’re specific to that department, but their labor goes over multiple jobs. So, depending on the size of the company you’ve got, you may not have indirect expenses. As I said before, if it’s yourself and a small crew, you have one department. So really everything either gets switched into a direct expense or an overhead expense category.
So, the last category of expenses we’re going to look at broadly here is overhead expenses. So, what’s an overhead expense? It is expenses that are incurred just by operating the business. If you have no projects going on, the meter continues to run. As the point here at the bottom is, these expenses are incurred. So, what are they? Well, they could be payroll. If you have an accountant on staff, if you have a human resource manager, anyone at the executive level. Maybe your sales team? If you’ve got payroll going on, that is an overhead expense.
There are also expenses that aren’t related to projects which include your utilities for running your shop, rent that you possibly might be paying, insurance coverages, and advertising and marketing expenses. Again, the meter continues to run. If you have no projects going, your overhead is still chewing through your working capital that you have in your business.
What is An Expense Impact?
So, what is an expense impact? It impacts the profitability and the cash flow of your business. An important point here, cash flow is king. It is blood flow to the brain of your business. If you cut off the cash flow, the business dies. So, expenses are paid for out of the cash flow. And general rule of thumb is direct expenses need to be paid for by the cash flow of the project that they were incurred for.
Indirect expenses should be paid for by the cash flow of the department and overhead expenses have to be paid for by the cash flow of the company overall. Ben Franklin said “Be aware of little expenses. A small leak will sink a great ship.” In other words, know where the cash is leaking from in your business and close up those holes. And an important part is just to understand your expenses. Where are the expenses incurred? Some expenses are good, you’ve got to have them, but are they contributing to the profitability of the business or are they drawing away from the profitability of the business? So, you’ve got to know your numbers.
All right, so let’s look at a few suggestions and remember it’s important that you work with an accountant who you can trust and who understands your business in your line of work. So, what can you do?
The first suggestion might be to use job numbers or project numbers to track your expenses. What does that do? It allows you to track your expenses. You can quickly look it up and judge the profitability of your project. And a lot of accounting systems will allow you to do job costing and you’ve got to be able to cost your projects to know was it profitable or wasn’t it?
And what that means is that you’ve got to know your numbers. Know how your projects are performing. Know where your expenses are going. Know when you begin to make a profit on your project. And again, I can’t emphasize it enough, work with a qualified accountant who has experience in your line of work.
So here at Construct-Ed we are working on a new accounting course for our members. Our focus is going to be just on basics on how accounting works within the construction industry. If it’s something that you’re interested in, let us know and we will let you know when it’s ready.
So, I’m just asking the editor here to keep track of any comments that might be made, and we’ll be definitely releasing some news on that upcoming and you can take a look at some future posts here on our channels and we will notify you when it’s ready.
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