Contract costing is the tracking of costs associated with a specific contract with a customer. For example, a company bids for a large construction project with a prospective customer, and the two parties agree in a contract for a certain type of reimbursement to the company. This reimbursement is based, at least in part, on the costs incurred by the company in order to fulfill the terms of the contract. The company must then track the costs associated with that contract so that it can justify its billings to the customer.
The most typical types of cost reimbursement are:
- Fixed price. The company is paid a fixed total amount for completing the project, possibly including progress payments. Under this arrangement, the company will want to engage in contract costing to compile all of the costs relevant to the construction project, just to see if the company earned a profit on the deal.
- Cost plus. The company is reimbursed for the costs it incurred, plus a percentage profit or fixed profit. Under this arrangement, the company will be forced under the terms of the contract to track the costs related to the project, so that it can apply to the customer for reimbursement. Depending on the size of the project, the customer may send an auditor to examine the company’s contract costs, and may disallow some of them.
- Time and materials. This approach is similar to the cost plus arrangement, except that the company builds a profit into its billings, rather than being awarded a specific profit. Again, the company must track all contract costs carefully, since the customer may review them in some detail.
Contract costing can involve a considerable amount of overhead allocation work. Customer contracts typically specify exactly which overhead costs can be allocated to their projects, and this calculation may vary by contract.
In some industries, such as government contracting and commercial construction, contract costing is the primary task of the accounting department, or may even be organized as an entirely separate department. Proper contract costing can contribute a considerable amount of profits, and so is typically staffed with more experienced contract managers and accountants.
Types of Contract
- Fisted price contract
- Fisted price contract subject to Escalation Clause.
- Cost plus contract.
Features of Contract Costing
- A contract is undertaken according to the specific requirements of customers.
- Generally, the duration of a contract is long period.
- The contract is undertaken only at the site of the customer.
- Contract work mainly consists of construction activities.
- The specific order costing principles are applied in contract costing.
- The size of a contract is usually large or bigger than jobs.
- It requires a long time to complete a contract.
- Each contract is an independent one, quite distinct from another.
- A distinctive number is assigned to each contract to differentiate the contract from one another.
- A separate account is maintained and prepared for each contract to find out the profit earned from each contract separately.
- If a contract is not completed at the end of the accounting period, only a portion of profit is transferred to profit and loss account on the basis of stage of completion of a contract.
- There is no problem of under absorption and over absorption of overheads.
- Every conceivable expenditure is charged to the concerned contract.
- If the materials, plants and other inputs are transferred from one contract to another, the transfer may be affected by giving debit and credit to the respective contracts.
- The proportion of indecent costs to total cost of a contract is very small.
- A contractor may appoint a sub — contractor(s) for the execution of the work of the main contract.
- The contractee i.e. the customer pays money only on the basis of the work certified by the architect, engineer or surveyor.
- Escalation clause may be incorporated in the agreement of the contract. It so, the contractor is protected from any rises in the prices of materials, labour and other inputs.
Procedure of Contract Costing
In contract costing, most of the expenses are direct in nature as in the form of materials, labour, expenses, plant, sub-contract charges and the like. Only a small portion of amount is charged as overheads which are apportioned on suitable basis. Accounting treatment of costs of contract costing is briefly explained below.
The value of materials used is debited in the concerned contract account. Materials may be specifically purchased from the open market, issued from the stores, transfer from other contracts or supplied by the contractee himself. If materials are returned to stores, the value of materials is credited in the concerned contract account.
Sometimes, materials may be transferred from one contract to another. If so, the value of materials is debited in the receiving contract account and credited in the transferring contract account. Whenever the materials are purchased from the open market, the values of materials are debited in the concerned contract account.
Similarly, if materials are issued from stores, the concerned contract account is debited and the stores control account is credited. Sometimes, some materials may be stolen or destroyed by fire, the value of materials is credited in the concerned contract as stores account and the same is transferred to profit and loss Account.
Generally, the contract is carried on only at the site of the contractee i.e., customer not within the company premises. Hence, labour is engaged at site to work on the contract. The amount paid to workers is wages which is directly debited in the concerned contract account. The details of information regarding wages are obtained from the records of time sheet and wages sheet. Equitable base method is usually adopted to apportion the wages of supervisors working on two or more contracts.
Likewise, the overheads are also apportioned on suitable basis. The accrued wages and outstanding expenses are calculated at the end of the accounting period and debited in the concerned contract account.
3. Direct Expenses
The direct expenses are debited in the concerned contract account as and when they are incurred. Examples of direct expenses are hire charges paid for the plant procured from outside, sub-contractor’s charges, architect’s fees, electricity, insurance and the like.
4. Plant and Machinery
The plant and machinery is treated in two ways. Under first method, the full value of plant and machinery is debited in the concerned contract account if the plant and machinery is specifically purchased for the contract. At the end of contract, the plant and machinery may be sold out in the market if it is not required further. If so, the sale proceeds are credited in the concerned contract account.
Sometimes, the plant and machinery may be required further, if so, the depreciated value or revalued amount of plant and machinery is credited in the concerned contract account. The net effect is that the contract account is debited with the amount of depreciation.
Under second method, the contract account is debited with the amount of depreciation of plant and machinery. The plant and machinery may be purchased specifically from the open market or issued from the stores. The amount of depreciation is calculated on the basis of daily use or hourly basis. Sometimes, a plant is procured on hire basis, if so, only hourly charges are debited in the contract account.
Indirect costs cannot be directly charged to any contract account. These costs are apportioned to all the contract accounts only on the suitable basis. These are called as overheads. The term overheads includes payment made to engineers, supervisors, architects, managers, store keeper, central office, administrative expenses like staff salaries, telephone expenses, postage, rent, stationery, advertisement expenses etc.