Contract costing serves as a framework in project oriented businesses like construction and engineering projects which helps to evaluate and manage costs associated with a particular project.
Contract costing is termed as a specialized form of job costing, that typically involves undertaking any project on a contract basis.
(1) What is Contract Costing?
Contract Costing, the term which is also being regarded as ‘Terminal Costing’ and a specialized form of job posting. As the name implies, it involves a specific contract in project oriented businesses like construction or engineering projects.
Here, a contract is made which specifies and tracks all the cost and details regarding a specific project.
Contract costing is a method which is applied to calculate, allocate, record and analyze every cost associated with individual projects or contracts.
It is referred to by some as Terminal Costing, because after the completion of work and all cost paying is done, the account is immediately closed.
Not only that, contract costing also takes in the detailed information and manages finances and accounting of indirect and direct revenues and costs of the project.
Apart from that it also involves fast billing or extending contracts to manage large scale projects which ensures long term efficiency and effectiveness.
In simple words, A contract costing is a form of special contract where the work is done according to the customer’s requirement and preferences and the cost is managed accordingly to the duration of the project.
The term is mostly used by contractors, engineers, or builders, who undertake definite contracts like construction of a building, house, bridge construction, and more like that.
The contract usually involves a fixed period and price (called contract price), which need to be paid either on the completion of the contract or on installments according to the progress of work done and the contract.
Let’s know the objectives of Contract Costing!
(2) Objectives of Contract Costing
| Objective | Reason |
| Correct Cost | One of the major objectives of contract costing is to determine the ascertainment i.e. to tell the cost of each product, process, or operation, and to ensure that all expenses are covered in the cost of the products, and the techniques. |
| Cost Control | The ascertainment of cost is not alone fully useful, it is also important to control the cost so as to reduce the cost of a product or service, and implementing lower the cost, higher the profit. |
| Profit Calculation | It also helps in calculating the profit that involves long term contrast. |
| Management Guide | Contract costing serves as an absolute great method for guiding on resource management and correct utilization of it. |
Above were the objectives that contract costing serves in a project.
Without any delay, let’s start with the key features of contract costing!
(3) Key Features of Contract Costing
Here, we’ll see the key features that a contract serves in a project oriented business.
| Key Features | Description |
| Individual Contracts | Here, each contract is taken as an individual contract which has a separate cost unit. Costs are calculated, recorded and accumulated individually for each contract. |
| Long Duration | Generally, contracts are longer which involve a completion period of more than a year. |
| Contract Division | When the contract completion duration serves a longer period than the contractor breaks it into small parts of the contract. |
| Direct Costs | Contract costing serves as a method for direct costing as it includes direct costing of labors, materials, and expenses specifically considering the contract. |
| Cost Control | It is crucial in managing cost structure against the contract value as it ensures the profitability and efficient use of the resources. |
| Site Work | Contract costing does not involve work in factories, instead all the work is done at the site only. The client can actually see how the work is done. |
| Retention of Money | Contract costing often includes retention of money, according to which the client can hold money with themselves until the work is done or completed. |
| Penalty Clauses | Some contracts also involve penalty charges or clauses according to which if the completion of work is delayed by the contractor, then the client has the power to charge a penalty on the contract. |
| Recognition of Profit | Some contracts involve the Recognition of Profit clause, in which the profit and revenue is recognized based on the stage of completion. That often involves using the percentage of completion method. |
| Change Orders | This results in addition to the actual cost. It occurs when any new thing is added or changes are done in the original contract which eventually results in the additional costs in the contract. |
| Close Account | The last stage of the contract costing. It is a process of finalizing and closing a contract, and clearing any outstanding issues and payments. |
As described in the table above, it marks the key features that contract costing serves in a business oriented project and also what benefits it offers.
Till now we discussed about what is contract costing, its features, now let’s move on to another major part of the discussion, i.e. types of contract costing!
(4) Types Of Contract Costing
Contract costing can be divided into three parts, i.e. Fixed Price Contracts, Contracts with Escalation Clause, and Cost Plus Contracts.
| Type of Contract Costing | Definition |
| Fixed Price Contracts | As the name suggests, here the contract involves a fixed and predetermined price. The contractor and the client both agree upon the fixed price set on the contract. The amount is paid to the contractor after the work is completed. It also increases the chances of risks involved. As any damage happened or risk occurred involves additional costs. |
| Contracts with Escalation Clause | Here, the contract involves the clause that the fixed price set in the contract may change due to the increase in process costs like material or labor increase. However, it is only implemented when both the parties agree on it. |
| Cost Plus Controls | Here, the client pays all the allowable costs to the contractor, and the contractor gets a fixed percentage of the profit or a fee that includes overall profits. Also no fixed amount is pre-determined for the contract. This contract is beneficial as it provides flexibility and the overall cost of the contract is defined by adding all the costs till date of completion. |
Now let’s look at some of the examples where contract costing is majorly used.
(5) Examples of Contract Costing
| Examples | Description |
| Construction Industry | Contract costing in the construction becomes an absolute necessary thing to be carried out. As building projects include various cost measures, equipment use, material use, overhead expense, etc. Therefore contract costing ensures that all these costs are tracked and covered. |
| Engineer Projects | It is a known fact that engineer projects involve various costs and long durations to complete. For example, completion of a bridge or a project assigned by the government. Here contract costing serves as a helping hand which guides and helps in tracking and managing all costs. |
| Consulting Services | Oftenly consulting services also relies on contract costing method, as it helps them in managing diverse projects, cost related to it and also tracking specific consulting contracts. |
(6) Contract Costing Pros & Cons
| PROS | CONS |
| Helps in doing accurate tracking of costs and control over it as each contract is taken as an individual contract and is monitored accordingly. | It can result in complex situations in cost tracking as the projects have long durations. |
| Effective profit recognition. This method also helps in recognizing profits according to the completion of the project. | Can result in cost overruns as long projects can include delays, change in design, material, labor required, etc. |
| Client management and satisfaction. As the work is being carried out on the site and the client can monitor the work as well. Also the regular billing and maintaining cash flow helps to build trust with the client. | As the projects take a long duration to complete, contractual disputes have higher chances to occur. |
| This method provides efficiency in long term projects, as when the projects are extended for long durations, contract costing ensures to provide a structured approach to the final project. | Lack of accounting and tracking may result in improper calculation and record maintenance of profits. |
Note: Do visit our article, Wealth Maximization vs Profit Maximization.
(7) Summing Up: What is Contract Costing?
Contract costing has served as a companion as well as an efficient tool in project oriented business. It offers a robust methodology for maintaining and tracking various costs within a business.
Was not known that contract costing has different types!