What is Contract Costing: Meaning, Features & Types Explained
Contract costing is a form of particular order costing that contractors generally apply for orders of a long duration. However, some prefer calling it "terminal costing" because after completing the work, the account is closed immediately.
In this practice, the principles of job costing and cost ascertainment are also applicable. However, even though this is significantly similar to factory job costing, it differs in size and duration.
What does Contract Costing mean?
As this name implies, contract costing is a process of tracking costs that are associated with a specific contract. Hence, this can be a specialised form of job costing. Nevertheless, this system only applies to jobs which include a contractual bond. For a better understanding, let us check an example. A company bids for a large project with a prospective client, wherein both agree to a contract of reimbursement to the company.
What Are the Objectives of Contract Costing?
There are only two major objectives of contract costing:
- Find a comparison between the actual cost with an estimated cost
- Analyse cost to provide a basis for cost-plus pricing
- Calculate profit over the long-term contract
- Guidance for managing resource utilisation
What Are the Features of Contract Costing?
The list below highlights the features of contract costing:
- Then, after carefully including clients' requirements, a contract is drawn. Therefore, it is highly unlikely that any of these contracts would be similar
- Each of these contracts is a distinct cost unit for the purposes of accumulating costs
- The structure of cost contact states that there are more direct expenditures in the form of materials, wages, and usage of stores or plants. Here, only a minimum charge is applicable for appointed overheads
- Contracts are for a longer period, typically more than a year
- The work is done at the site because it is difficult to exercise cost control
- Each contract has separate accounts to determine profitability
- Every contract work that involves construction must be done at customers’ sites and not on factory premises
- The amount a client pays depends on the work completion stages, which need prior approval
- In case of any delay in completing the work, contractees are liable to charge penalties. Similarly, the contractors get bonuses if they complete the work on time
- Sometimes, an original contract is divided into several parts, out of which specialists assign some jobs through outsourcing
- The people in charge can purchase plants and equipment or hire them for a particular period
- These contracts include difficulty in valuation or work-in-progress status at the end of each accounting period
- Mostly these contracts take one year or more to complete. Hence, it is common to transfer a certain percentage to their account by the end of each accounting year until the completion of the project
Examples of Contract Costing
Till now, we discussed that contract costing requires the involvement of two parties, one who undertakes a project and completes it, and the other is the owner of that job or project. So here are some examples to understand this concept better.
A bridge is needed over a river at a particular site, and a client gives a contractor this assignment. A contractor opens separate accounts for each contract and numbers them separately to identify any profit or loss made at each contract. In addition, once the work for each contract is done, the respective accounts are closed.
Here is a contract costing example for better understanding.
Let us assume ABC contracting company has the following expenses:
| Particulars | Amount |
|---|---|
| Direct labour | ₹ 265,000 |
| Direct material | ₹ 1,150,000 |
| Direct expenses | ₹ 310,000 |
| Indirect expenses | ₹ 250,000 |
| Other estimated expenses | ₹ 190,000 |
| Settled contract price | ₹ 3,150,000 |
| Work certified | ₹ 2,500,000 |
| Work uncertified | ₹ 150,000 |
| Cash received | ₹ 2,100,000 |
| Work completion | 85% |
Solution
Here is a solution of contract costing based on this data for ABC company.
| Particulars | Amount |
|---|---|
| Direct labour | ₹ 265,000 |
| Direct material | ₹ 1,150,000 |
| Direct expenses | ₹ 310,000 |
| Indirect expenses | ₹ 250,000 |
| Total expenses | ₹ 1,975,000 |
| Other estimated expenses | ₹ 190,000 |
| Total estimated cost | ₹ 2,165,000 |
| Work completion | 85% |
| Settled contract price | ₹ 3,150,000 |
| Revenue (recognised) | ₹ 2,677,500 |
| Cash received | ₹ 2,100,000 |
| Progress billing | ₹ 577,500 |
| Notional profit | ₹ 512,500 |
| Estimated profit | ₹ 925,000 |
What Are the Types of Contract Costing?
There are three prevalent types of contract costing:
1. Fixed Price Contracts
A contractor and a contractee agree upon a fixed price in this type of contract. Then, after the completion of that job, a project owner or a customer pays that amount to a contractor.
If there are any defects in the work, the contractor is liable for deducting a certain amount as penalties. This can also happen in case of delay in completing the work. Moreover, extra payments are given if any additional work is done.
2. Contracts with Escalation Clause
Contracts like these have a provision that the fixed price may increase or decrease in certain situations. Moreover, these are only relevant when both parties mutually agree on this procedure.
For example, the total amount increases with a hike in material cost, wages, or other major costs. Whereas if there is any reduction, it implies the overall cost.
3. Cost Plus Contracts
Such contracts make it difficult to assert any cost in advance. In situations like this, no fixed amount is pre-determined for the contract.
A client pays all the allowable costs to a contractor. In addition, the contractor gets a fixed percentage of the profit or a fee for overall profits.
What Are the Advantages and Disadvantages of Contract Costing?
The following tables highlight the advantages and disadvantages of contract costing from the respective viewpoints of a contractor and contractee.
For the Contractor
| Advantages | Disadvantages |
|---|---|
| A contractor has an assurance of a fixed profit margin | Discourages a contractor to take any measure for cost reduction as profit is based on the cost |
| Lesser chance of incurring any loss on the contract | There are chances of disputes arising among parties |
| Any fluctuations in the market do not affect the contractor | |
| Tenders' submission becomes simple. |
For the Contractee
| Advantages | Disadvantages |
|---|---|
| Since the price is based on actual cost, this satisfies their needs | Encourages wastage of resources, as the higher the cost more the profit will be |
| A contractee has protection | The amount a contractee needs to pay is uncertain as it depends on the completion of work. |
As you have read so far, you now know the meaning of contract costing and some other fundamentals of this method. To recap, here is a definition by The Chartered Institute of Management Accountants (CIMA). “This specific order costing is applicable wherein work is done per a customer's special requirements. Usually, such works are constructional, and the method is akin to job costing.”
FAQs About Contract Costing
What are the elements of contract costing?
The top nine elements of contract costing are materials, labour, plant and machinery, indirect expenses, escalation clause, sub-contracts, cost plus contracts, extra work, and work in progress.
Which are the industries where contract costing can be suitably applied?
Readymade garments, pharmaceutical, manufacturing industries, construction companies or those who undertake engineering projects, and public works are some industries that use contract costing.