Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
When asked to define costs in construction, the standard response includes land, materials, labor, subcontractors and equipment. All of these are required to build a home or any type of project. This would appear as a good answer. Notice how all the items are tangible in nature. You can see the land, touch the materials, shake the hand of the worker and smell the fumes from the exhaust of the equipment. These costs are commonly referred to as hard costs. They are directly measurable to a job. However, there are other costs that are necessary to get the house or project completed.
These other costs don’t really transfer once the project is done; they seem to just dissipate into thin air. Here are some examples:
- Transportation of the materials and labor to the job site
- Project Management
- Debris removal, port-a-john, utilities while the project is under construction
- Interest on the capital to build the project
All of the value of these costs disappear once the project is over. You don’t leave the port-a-john or the environmental barrier behind once the house is sold. All of these costs are commonly referred to as ‘Soft‘ costs with construction.
Sure, all of the costs above are required, but why do we need to know the difference between hard and soft costs? The answer is simple. When estimating or valuing the end result of all this work, we have to ‘Markup‘ our costs in order to calculate the final sales price for the contract. It is almost impossible to markup soft costs. Yes, it can be done; it requires some pretty smart accountants to do it, but it can be done. That level of administration is expensive and thus, small contractors (contractors with sales less than $50 Million per year) can’t afford to pay for this level of sophistication. Therefore, smaller contractors markup on hard costs only. Thus, a contractor must understand the difference between ‘Hard‘ and ‘Soft‘ costs.
The reader may want to know: how can it be so hard to markup soft costs? Let’s explore this for a moment and then get back to identifying hard and soft costs.
Indirect Costs of Construction
Most soft costs incurred by the contractor are not directly identifiable to a job. Almost all contractors use job costing to evaluate performance; comparing directly assignable costs against the estimated amounts to determine project profitability. When materials are purchased, the receipt or bill is assigned to a job and often an item code (phase code). Soft costs are different.
When the contractor stops in at the gas station and buys fuel for his truck, what job does he assign that ticket? He is going to use that fuel to drive to many job sites over a course of a few days. The initial thinking is to allocate that ticket to the jobs he does go to during his work. This will require a log and a spreadsheet to do this. It is very cumbersome to allocate indirect costs, it requires an administrative staff to do this and it isn’t worth the knowledge you will receive.
Other indirect costs that are commonly incurred for a contractor and cannot be allocated to jobs include:
- General Liability
- Builder’s Risk
- Worker’s Compensation
- Lease Payments
- Auto Insurance
- Repairs and Maintenance
- The Dashboard Bobble Head
- Communications (cell phones and radios)
- Project Management
- Health Insurance
- Safety Equipment
- Professional Development (Training)
Most these costs are generally intangible in nature and thus indirect costs are referred to as ‘Soft’. The key is that these costs are difficult to assign to a particular job because they are used across many jobs over long periods of time. Thus, the construction industry uses two types of costs to build a project.
Those costs required and directly assignable to a job are called hard costs. These costs may either be tangible or intangible. Wait a minute Dave, you just said above that soft costs are generally the intangible costs. Yes, that is correct, but that is in general. There are lots of intangible costs that are directly assignable to the project. Here are many examples:
- Permits – Here’s a piece of paper that will disappear once the project is transferred to the buyer.
- Environmental Fence – Although tangible, it too will need to be removed once the project is done.
- Engineering/Plans – Definitely intangible, but is necessary to comply with the law.
- Utilities – It is tuff to make mortar without water; the final product is tangible, but this ingredient evaporates once the chemical bond is completed.
- Inspections – Similar to the permit above
- Interest – The bank requires interest to be paid on the project note during the construction period, the interest is definitely assignable to a particular project.
- Debris Removal/Facilities – Every project must address trash and the worker’s needs while on the job site.
What is interesting is that all of these costs are intangible in nature but directly assignable to the job. Since the costs are directly assignable to the job, they are referred to as ‘Hard‘ costs. Thus, hard costs are not only tangible costs, but also intangible contingent on assignability to the respective job. The key is that all hard costs are directly assignable to the job.
All hard costs are directly assignable to the job. These costs are most often tangible in nature, but there are many intangible costs that can be directly assigned to the job. Thus, some intangible costs are ‘Hard’ costs.
- Vehicle Operations
- Management Team
The key to defining soft costs is this: costs are not directly assignable to a job. Thus, the above list is general in nature. You can indeed have a long-term project whereby certain vehicles are purchased solely to complete that project. The same is true with a project manager, he may be assigned to a particular construction site for an extended period of time. This is very common with large government backed projects such as the construction of a school or a hospital. In those cases, these costs are reclassified as hard costs because they are directly assignable. But the for small contractor, this isn’t the case.
The small contractor requires the project manager to manage several jobs over different time periods. Thus, every time the payroll is run for this individual, it is nearly impossible to allocate the project manager’s compensation to a job. His compensation is allocated to indirect costs of construction.
To help the reader understand, let’s review a typical income statement presentation format to equate hard costs and soft costs related to construction.
Income Statement (Limited Presentation)
For the Year Ending December 31, 2018
Closed Contracts $ZZ,ZZZ,ZZZ
Costs of Construction
– Land/Materials $Z,ZZZ,ZZZ
– Labor/Subs Z,ZZZ,ZZZ
– Other ZZZ,ZZZ
Sub-Total Direct Costs ZZ,ZZZ,ZZZ
– Management ZZZ,ZZZ
– Transportation ZZZ,ZZZ
– Insurance/Bonding ZZZ,ZZZ
– Communications ZZ,ZZZ
– Equipment ZZZ,ZZZ
Sub-Total Indirect Costs Z,ZZZ,ZZZ
Gross Profit Work Completed $Z,ZZZ,ZZZ
Direct costs are the hard costs of construction and include many intangible costs such as permits, engineering and interest (‘Other’ line in the report above) to build the projects. Indirect costs are the soft costs of building the projects. Take note, soft costs do not include office operations. Office operations and other administrative costs are grouped in the expenses section of the income statement which is located beneath the gross profit line from work completed.
Some other interesting notes related to soft costs. Some estimators and contractors believe that sales tax on materials is a soft cost. NO! Sales tax is a cost of the materials and therefore it is a hard cost to the project; i.e. it is directly assignable to the project. When estimating material costs, the estimator must include sales tax for the cost of materials. Some other examples of common mistakes for soft costs which are directly assignable and thus are hard costs include:
- Delivery Fees for Materials
- User Fees such as offloading materials and pallet usage
- Equipment Rental (Why would a contractor rent equipment to sit around and look pretty? The contractor rents it for a job.)
Unlike what many other so-called authorities may state, hard costs are actually costs that are directly assignable to the job, they are not simply tangible costs. Hard costs have a perfect correlation to need from the job. It is relatively easy to understand this with tangible items such as materials, but there are many intangible costs that necessary to get that job done. Thus, hard costs can be intangible in nature, but all hard costs are directly assignable to a job. his This works well with job costing and estimating jobs.
Soft costs are most often intangible in nature but can be tangible. Soft costs are costs that cannot be directly assignable to a job. These costs are generally incurred as a function of being a contractor and not because of a single job. Soft costs are customarily grouped into the section of the income statement called indirect costs of construction.
Markup on jobs is calculated off hard costs. Thus, markup must take into consideration the overall average of soft costs to get jobs done. This is an important concept for the next article related to this subject; MARKUP IS A FUNCTION OF HARD COSTS, BUT MUST COVER SOFT COSTS, OVERHEAD AND PROFITS. Act on Knowledge.