What is Contract Costing?

Contract costing is about tracing particular costs related to a particular contract entered into with the customer. It is one of the forms of job order costing. It is useful in long-term contracts at the most. It is seen that substantial time is required for the completion of the contract which takes different accounting periods. Thus, it is very much helpful for recognizing the costs associated with it and accounting in their specific accounting periods.

Here, the work agreement is closed once the whole work is completed and the contract is closed after the termination of the work. Hence, it is also called "Terminal costing". Most of the expenses in contract costing are generally of a direct nature.

There are various costing methods which are generally put into implementation such as job order costing, batch costing, process costing, contract costing, etc. But contract costing is very much useful to the contractors who undertake construction work and engineering work like buildings, bridges, roads, canals, railway lines, etc.

Customers have different and specific requirements and for fulfilling such requirements, contract costing is applicable so that the long-term contract is completed within a specific time and with a specific contract cost which ultimately leads to profit for the contractor and the owner. 

Examples

1. The best instance of contract costing is “Delhi Metro” and “Konkan Railway”. Here, two parties have an agreement between them. First is the contractor (who takes the work to be completed) and the second one is contractee (owner or the person for whom the work is completed).

2. Another good example is the construction of a bridge on a river at a given site. When the bridge is fully constructed, the agreement will be terminated. 

Features of Contract Costing

1. Different accounts: Separate account is made for every different contract and such accounts are separately maintained under contract costing.
2. Direct expense: Some expenses are directly associated with the worksite and such expenses are to be considered as direct expenses.
3. Cost unit: Contract costing is mainly adapted for considering the cost unit of the contract which is very much useful for accounting too.
4. Overheads: Various overheads like fixed overhead, variable overhead, semi-variable overhead, etc. are incurred and considered while costing each contract.  
5. Contract price: Buyers and sellers agree at a specific amount of consideration which is said to be contract price. The making of contract account generally leads to notional profit.
6. Specification: Contracts are mostly executed as per the specific requirements and costs of such are incurred as per the specifications.

Types of Contracts

1. Fixed Price Contract
2. Cost-Plus Contract
3. Contract with Escalation Cost

Fixed Price Contract

A contract in which contract price is not dependent on time or resources used, instead, the price is fixed at the agreed amount and no other additional costs are applied. This is most useful where less risk is associated and the cost of the whole project is also predetermined. It is adapted in various fields because of its simplicity and avoidance of complicated billing processes. Here, payment is not dependent on the time and resources expended.

Exceptions:

Some deductions are made for any defects or penalties. If additional work is done then an additional contract price is being charged.   

Advantages:

• Cost certainty: It gives both buyer and seller a predictable price and removes the concerns regarding the cost of goods or services and income from such goods and services.
• Concrete budget: Here, both parties do not have to worry about their budget regarding pricing or overheads incurred in the project.

Disadvantages:

• Market change: Changes in market situation like inflation or deflation will affect both the parties like an increase in the price of material and labor.
• Higher price: Mostly such agreements are fixed at a higher price than the normal as there are uncertain risks in the future which ultimately lowers the profit.

Cost-Plus Contract

In a cost-plus contract, parties make an agreement in which price is determined as expenses incurred along with specific gain i.e., cost incurred plus profit. Here, the contractor compensates all the costs incurred to the contractor plus a percentage of the cost as gain or a lump sum amount.

Advantages:

For the contractor

• The contractor will get a fixed profit margin in this type of contract.
• Chances of loss are very much lower.
• Changes in the market prices of overheads do not affect the contractor.
• Tender submission becomes very much easy.

 For the contractor

• The needs of the contractor are satisfied as the price is based on actual cost.
• Here, the contractor gets full protection even in the worst situation or condition.

Disadvantages:

  For the contractor

• There exists a challenge for the contractors to reduce the cost as much as possible because all the profit is based on the cost, so disputes can arise between the parties.

For the contractor

• As the gain is directly related to cost so expenditures with no use are reduced and thus large gains will be there with high costs.
• The total amount which is to be paid by the contractor will not be determined until the whole work is completed and thus uncertainty of the amount will result in a lack of cash management.

Contract with Escalation Cost

A contract with escalation cost is the combination of fixed price and cost-plus contract. Here, a clause known as an escalation clause is inserted in the agreement for fluctuation in the prices of material, labor, or other overheads. For instance, if the price of the material and labor increases by 5% then this clause will give the right to the contractor to claim a higher value.

Advantages:

• Negotiation: The buyer has a good chance of negotiating the price at the time of the agreement.
• Risk-free: The contractor has less risk in this type of agreement because of the escalation clause as it has the cover for any losses in the future due to inflation or deflation in the prices of material, labor, or other overheads.

Disadvantages:

• There is only one disadvantage which is to the contractor as there is a chance of good negotiation in the price due to the escalation clause. As a result, the contractor can bargain as much as he can and this will affect his benefits.

Accounting of Contract Costing

When a contract is not completed in an accounting period then profit of such is calculated and accounted for. Some points which are to be kept in mind while calculating the profit are as follows.

1. If certified work is less than 25% of the price then profit should not be calculated and accounted for in the contract account.
2. If the certified work is more than 25% of the price and less than 50% of the price then the profit should be disclosed as the percentage of cash received.
3. If the certified work is more than 50% and less than 66-2/3% of the profit, it should be disclosed as the percentage of cash received.
4. Uncertified work is always valued at cost.
5. If there is a loss then it is transferred to the P&L account.

Formulas

Objectives of Contract Costing

1. Cost comparison: Actual cost is compared with an estimated one to find the undervalued or overvalued prices.
2. Detailed analysis: Costs are analyzed to provide a basis for cost-plus pricing.
3. Guidance: It guides the management in using resources so that they can take proper decisions regarding resources expenditure at proper place and time.
4. Benefit: Gain is calculated each year on a reasonable basis on contract work so that a clear picture of the whole contract work can be calculated and data regarding work in progress and work completed can be analyzed.

Applications

Industries where contract costing is mainly used are

• Manufacturing industries.
• Pharmaceutical industries.
• Railway lines.
• Construction of buildings, roads, ships, dams, etc.
• Readymade garments.
• Real estate.

Inclusions in Contract Costing

1. Contract Account: Each agreement is given a separate account number.
2. Direct Cost: These are directly allocated to the contract and are debited to the contract account. Direct costs are Material, labor, depreciation of plant and machinery, etc.
3. Indirect Cost: These are not directly allocated to the contract but are necessary for the completion of the contract. Indirect costs are such office expenses, storage expenses, etc.
4. Profit or Loss: Profit is transferred to the P&L account in each accounting year. However, if it is not completed then some specific proportion of gain is undertaken for accounts.

Context and Applications

The topic is significant in the professional exams for both undergraduate and postgraduate courses, especially for

• B. Com (Bachelor of Commerce)
• BBA (Bachelor of Business Administration) in Finance
• MBA (Master of Business Administration) in Finance
• CA (Chartered accountant)
• CFA (Chartered Financial Analyst) Program
• ICWAI (Institute of cost accountant of India)

Related Concepts

• Standard costing
• Job costing
• Batch costing
• Process costing
• Operation costing