Contract costing

From CEOpedia | Management online

Contract costing is also known as terminal costing. It is one of the methods of job costing. In this method, each contract is a cost unit and an account is opened for each contract in the books of the contractor to ascertain profit or loss thereon. In contract costing, most of the costs are chargeable direct to contract accounts. Contract costing involves a lot of expenditure. Contracts, which are involved in contract costing are, generally, construction works or repair works. Contract costing is applicable in: building construction, road and bridge construction and ship building (D. Davis, P. S. Anton 2016)

Features of contract costing

Contract costing usually shows the following features:

  • Contract generally takes more than one year to complete.
  • A contractor usually carries out a small number of contracts in the course of one year, because contracts are generally of large size.
  • Nearly all labour is direct.
  • It is carried out outside the factory of the concern undertaking the contract.
  • Each contact undertaken is treated as a cost unit.
  • In the books of the contractor there is a separate contract account, which is prepared for each contract to ascertain profit or loss on each contract ((M.N. Arora 2013, p. 8.0)
  • For failing to complete the work within the agreed period penalties may be incurred by the contractor
  • Each contract involves most of the materials, which are specially purchased for it. These will, therefore, be charged direct from the supplier's invoices. Any materials drawn from the store is charged to contract on the basis of material requisition notes.
  • Most expenses (for example electricity, telephone, insurance) are direct.
  • Specialist sub-contractors may be employed for say, electrical fittings, welding work, glass work
  • Plant and equipment may be purchased for the contract or may be hired for the duration of the contract.
  • Payments by the customer (contractee) are made at various stages of completion of the contract based on architect's certificate for the completed stage.
  • An amount, known as retention money, is withheld by the contractee as per agreed terms (M.N. Arora 2013, p. 8.0).

Contract costing procedure

The basic procedure for costing of contracts is as follows:

  • Contract account. Each contract is allotted a distinct number and a separate account is opened for each contract.
  • Direct costs. Most of the costs of contract can be allocated direct by to the contract. All such direct costs are debited to the contract account. Direct costs for contracts include:
  1. Deprecation of plant and machinery
  2. Materials
  3. Labour and supervision
  4. Direct expenses
  5. Sub-contract costs
  • Indirect costs. Contract account is also debited with overheads which tend to be small in relation to direct costs. Such costs are often absorbed on some arbitrary basis as a percentage on prime cost or materials or wages. Overheads are normally restricted to head office and storage costs (M.N. Arora 2013, p. 8.0)
  • Transfer of material or plant. When materials, plant or other items are transferred from the contract, the contract account is credited by that amount.
  • Contract price. The contract account is also credited with the contract price. However, when a contract is not complete at the end of the financial year, the contract account is credited with the value of work-in progress as on that date.
  • Profit or loss on contract. The balance of contract account represents profit or loss which is transferred to Profit and Loss Account. However, when contract is not completed within the financial year, only a part of the profit arrived is taken into account and the remaining profit is kept as reserve to meet any contingent loss on the incomplete portion of the contract (M.N. Arora 2013)

Examples of Contract costing

  • Building construction: In this example, a contractor will record all the costs associated with the building construction project including the cost of raw materials, labor costs, overhead costs, and the cost of any subcontractors. The total cost of the project is recorded in the contract cost account, and the amount of profit or loss is also calculated.
  • Road and bridge construction: In this example, a contractor will record all the costs associated with the road and bridge construction project such as the cost of raw materials, labor costs, overhead costs, and the cost of any subcontractors used. The total cost of the project is recorded in the contract cost account, and the amount of profit or loss is also calculated.
  • Shipbuilding: Shipbuilding is a highly specialized type of construction project, and contract costing is used to track the costs associated with this project. This includes the cost of raw materials, labor costs, overhead costs, and the cost of any subcontractors used. The total cost of the project is recorded in the contract cost account, and the amount of profit or loss is also calculated.

Advantages of Contract costing

Contract costing has several advantages. Firstly, it helps in the accurate measurement and assessment of expenses incurred on each contract. Secondly, it ensures that all costs related to a particular contract are taken into account when calculating the profits or losses. Thirdly, it helps identify and control cost overruns and minimize wastage of resources. Fourthly, it helps in the efficient administration of contracts and provides the contractor with a better understanding of job costs. Lastly, it allows the contractor to compare the cost of a project to the estimated cost. This information is then used to improve the accuracy of future estimates.

Limitations of Contract costing

The limitations of contract costing are as follows:

  • It is difficult to accurately determine the costs of a contract since the costs can change over a period of time due to changes in market conditions and the type of contract.
  • Contract costing is difficult to control due to the nature of the contracts which can vary in size, scope and complexity.
  • In contract costing, it is difficult to allocate overhead costs accurately to each contract as these costs may be difficult to measure and may be shared across multiple contracts.
  • Contract costing does not provide visibility into the profitability of individual contracts.
  • Contract costing does not provide a way to measure the efficiency of the project.
  • Contract costing does not provide a way to compare the performance of similar projects.

Other approaches related to Contract costing

  • Activity-Based Costing (ABC): This approach is used to determine the cost of activities required for a particular contract. It involves analyzing and allocating the costs associated with each activity or group of activities for a contract.
  • Process Costing: This approach is used to determine the cost of a contract based on the different processes involved. It involves breaking down the cost of a contract into different processes and then assigning costs to each of them.
  • Job Order Costing: This approach is used to determine the cost of a contract based on the individual jobs involved. It involves assigning costs to each job in the contract and then calculating the total cost of the contract.
  • Value Analysis: This approach is used to determine the cost of a contract based on the value of the materials used. It involves analyzing the costs associated with each material and then assigning them to the contract.

In summary, contract costing involves a number of different approaches such as activity-based costing, process costing, job order costing, and value analysis. Each approach is used to determine the cost of a contract based on the specific activities, processes, jobs, and materials involved.


Contract costing — recommended articles
Applied overhead — Progress billings — Normal cost — Cost element — Conversion cost — Underapplied Overhead — Direct labor cost — Sub ledger — Inventory accounting

References

Author: Beata Franczyk

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