HOW TO KNOW IF YOUR CONSTRUCTION OVERHEAD RATE IS WRONG — FIVE TESTS.
Most contractors who have an understated overhead rate do not know it. The symptoms are there — busy but not making money, jobs closing below estimated margin, LOC growing with revenue — but the cause is not obvious without running the diagnostic. Five tests, in order of speed. The first one takes 20 minutes. If it fails, the overhead rate is wrong.
SPM runs this diagnostic on every new engagement. Most clients fail at least three of the five tests on the first pass.
HOW TO TELL IF YOUR OVERHEAD RATE IS UNDERSTATING THE REAL COST OF RUNNING YOUR BUSINESS.
Compare Estimated to Actual Gross Margin on Last 5 Projects
Pull estimated gross margin from the bid and actual gross margin from the job cost at closeout on the last five completed projects. If actual is consistently 4–8 points below estimated, and the field execution was normal, the overhead rate is almost certainly understated. The projects are performing as estimated in the field. The overhead allocated to those projects is less than the overhead being incurred. The gap shows up as lower-than-expected net margin even when jobs look profitable.
Recalculate the Overhead Rate From Scratch and Compare to the Bid Rate
Sum every fixed cost line item from the last 12 months of actual expenses. Add owner compensation at market rate. Divide by last 12 months revenue. If that number is more than 2–3 points above the rate currently used in bids, the bid rate is wrong. A contractor using 11% in bids whose real rate is 17% is underpricing by 6 points on every project. On $3M revenue at 6 points of understatement, that is $180,000 per year in overhead that is never recovered.
Check Whether the LOC Balance Has Grown Alongside Revenue
A business that has grown revenue from $2M to $4M and also grown LOC utilization from $150K to $320K is funding overhead from credit rather than from project revenue. If the business were correctly priced, growing revenue would produce growing cash, not growing LOC utilization. When LOC grows with revenue, the most common cause is overhead understatement in the bid rate.
Ask Whether Owner Compensation Is in the Overhead Rate
Most owners who take draws rather than a defined salary do not include their compensation in the overhead rate calculation. Pull the overhead rate calculation. Find the owner compensation line. If it is missing or below $100,000 at $2M–$5M revenue, the overhead rate is understated by the missing amount as a percentage of revenue.
Compare Net Margin to the Target After Overhead
At the current gross margin target and the current overhead rate: what should net margin be? Compare that to the actual net margin over the last 12 months. If the actual is more than 3 points below the theoretical, the overhead rate used in bids is below the overhead rate actually being incurred.
THE CORRECTION SEQUENCE THAT FIXES THE BID RATE WITHOUT LOSING WORK.
The market pricing reality: If the correct overhead rate produces bid prices that lose all competitive work, the market is pricing below true cost across all competitors. That is a different problem — one that requires scope selection, market repositioning, or overhead reduction rather than rate acceptance. But in most markets, correcting an understated overhead rate by 4–6 points produces a win rate that remains competitive because competitors are also absorbing the gap from margin.
FREQUENTLY ASKED.
