Capitalization of Overhead (Meaning)
The average business entrepreneur will define costs of construction as land, materials, labor, subcontractors and equipment used to construct the improvements. In reality, there is much more. Accountants, bankers and governmental compliance agencies commonly refer to the above costs as ‘Direct’ costs. Basically, they are the costs that comprise the physical structure. There are also costs that are not a part of the real estate but are required in order to construct the improvements. These costs are intangible in nature and are necessary to get the job done. They include:
- Other Direct Costs of Construction
- Closing Costs upon Purchase of the Land
- Interest on Loans/Bonds
- Taxes (Real Estate, Grantor’s, Title Fees Etc.)
- Association Dues Throughout Construction
- Site Utilities (Water, Electricity, Sewage)
- Environmental Protection (Drainage, Port-A-John, Fencing Etc.)
- Debris Removal
- Management (Project Manager, Site Foreman, Outside Consultants)
- Transportation/Lodging/Per Diem
- Insurance (Builder’s Risk, Worker’s Compensation, Equipment, Bonding Etc.)
The above costs have various names as a group including: Indirect Costs, Project Burden and Job Operating Costs. The key to the above is that none of the costs are physical in nature and you can’t see them once the project is completed. Yet, without them the contractor can’t realistically build the project. Its these costs that are classified as construction overhead. There is one more important note for the reader to understand.
All of the above costs relate to construction of a project and have nothing to do with the office expenses nor ownership of the company. Think of the physical separation of the project from the main office. Those costs to run the main office are commonly called ‘Expenses’ in accounting and are understood to be general or administrative (G&A). They are reported in the expenses section of the income statement (profit and loss statement). The above overhead costs are reported in the Costs of Construction section of that financial report. To illustrate, below is a summary format of a simple income statement for a contractor:
Income Statement (Summary Format)
12 Months Ending 12/31/18
Contractual Sales $ZZ,ZZZ,ZZZ
Direct Costs (Z,ZZZ,ZZZ)
Construction Overhead (Z,ZZZ,ZZZ)
Gross Profit Z,ZZZ,ZZZ
Net Profit $ZZZ,ZZZ
In general, these overhead costs are grouped together as a pool of costs because the contractor is involved in multiple projects and not just a single project. This pooling of costs are then allocated to the projects each accounting period based on a reasonable formula and assigned to each project. This process is referred to as capitalization of overhead.
Over the last 50 years of business it has become the standard of accounting as it is advocated by not only the IRS, as mandated by Congress, but also by the authorities that head of the world of accounting. It is widely accepted as normal because these overhead costs have become a much greater portion of the overall costs of construction in comparison to 50 years ago. Today, these costs range from 11% to as much as 40% of the costs of construction for a project depending on the nature of the project and the number of parties involved. A typical custom home contractor will incur around 23% of the entire cost to build the home from indirect costs. For Congress, the problem with overhead is that in the past, the typical contractor would immediately expense all these indirect costs while the direct costs were accumulated onto the balance sheet via the work in process (construction in process/progress) account. In effect, the contractor is accelerating their deduction to determine profitability, thus reducing their respective tax obligation. To alleviate this, Congress mandated the requirement to capitalize these respective costs. By capitalizing the costs, the contractor is forced to take the deduction in the year the project is completed and posted to the income statement (customarily done under the completed contract method of accounting). Thus, there is an additional burden to pool and allocate the indirect overhead costs to projects.
For those of you reading this, one of your thoughts will be: How on earth do I track this information? And, ‘Do I really have to capitalize overhead?
Accountants are taught during their formal education how costs are grouped (pooled) and then allocated to production. It is simply a matter of setting up the chart of accounts and then modifying the accounting process to perform this function. The problem with this is the associated administrative costs to get this done. It isn’t really economically feasible for small contractors (those doing less than $50,000,000 per year in sales). Under the rules of accounting, it is only required for publicly traded entities, those that must provide formal financial statements to investors. Therefore the small business entrepreneur is not required to follow these rules. It doesn’t mean it isn’t a good idea, it just means that accounting profession’s rules do not apply to you.
However, there is one entity that does have the authority to make your company comply with its rules. These are our friends at the Internal Revenue Service. They are required by Congress to make construction companies follow certain rules. The capitalization of overhead costs is a congressional requirement and is codified under Section 263(a) of the Internal Revenue Code. It is the law of the land.
So does this mean you have to capitalize these indirect costs?
NO IT DOESN’T.
This section of the Code actually has an exception for small contractors. Congress recognizes the costs to formally administer its rules and understands the impact to the small contractor. Therefore, small contractors are exempt. Now, we just need to define a small contractor.
The Code created two rules to identify small contractors.
Rule #1: Any contractor having sales of less than $50,000,000 (50 Million) per year is considered a small contractor.
Rule #2: If you have sales of more than $50,000,000 per year, you may be exempt from capitalizing overhead if you are doing either of the following:
A) The contractor’s average sales over the last three years must be less than $50,000,000 per year; OR
B) If you are a building custom homes and they are completed and closed in less than two years, you are eligible for exemption.
You must be a home builder to utilize B above. Also, all your contracts must be completed, i.e. closed within two years. Congress uses the two year exception because, the mathematical results are exactly the same tax wise related to a contract within a two year window. Basically, accelerating overhead costs in the current year by immediately expensing them forces the contractor to pay the tax on the increase in profit the following year when the contract is finally completed and the contractor has no overhead costs associated with that project to deduct. In accounting, we refer to this as merely a timing difference.
Summary – Capitalization of Overhead
Capitalization of interest is required of all contractors as mandated by Congress and Generally Accepted Accounting Principles. Because of the administrative costs to do this, it isn’t warranted for small contractors. Congress defines a small contractor as a builder with sales of less than $50,000,000 per year or a residential home builder that completes the home including the final sale within two years of starting the contract. Seek guidance from your Certified Public Accountant if you are a small residential contractor to confirm if the rule is applicable to your company. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.