Contract Costing, Concept, Objectives, Nature, Types, Procedure, Elements, Advantages, Limitations and Example

Contract costing is a form of specific order costing used to determine the costs incurred in executing large-scale, long-term contracts. It is commonly applied in industries like construction, engineering, shipbuilding, and infrastructure development, where each contract is substantial in value and extends over months or even years.

In contract costing, each contract is treated as a distinct cost unit. A separate account is maintained for every contract to track all costs related to materials, labour, equipment, overheads, and subcontracting. The costs are accumulated over the life of the contract, and revenues are recognized based on the percentage of completion or stage of certification by clients.

Direct costs like materials and labour are charged directly to the contract, while indirect costs or overheads are apportioned. Work-in-progress, work certified, and work uncertified are important elements in determining the profitability of an ongoing contract.

The aim of contract costing is to monitor expenses, control budgets, and assess profitability for each contract individually. It also facilitates progress billing, project accountability, and performance evaluation. This system is essential where jobs are unique, high-value, and executed off-site or at client locations.

Here are different definitions of contract costing:

General Definition

Contract Costing is a method of specific order costing used to ascertain the cost and profit of large-scale, long-duration contracts, where each contract is treated as a separate cost unit. It involves recording and monitoring all costs directly attributable to a particular contract.

Institute of Cost Accountants of India (ICAI) Definition

“Contract costing is that form of specific order costing which applies where the work is undertaken to customers’ special requirements and each order is of long duration, such as construction of buildings, shipbuilding, and civil engineering contracts.”

Accounting Textbook Definition

“Contract costing is a system of costing used for large jobs that extend over a long period and are performed outside the factory premises, with each job being treated as a cost unit and accounted for separately.”

Practical Definition

“It is a cost accounting method where the total costs incurred on a construction or installation project are collected and matched against revenue to determine profit or loss, allowing progressive billing and monitoring of project performance.”

Objectives of Contract Costing:

• To Determine the Cost of Each Contract

The primary objective of contract costing is to ascertain the total cost incurred on a specific contract. This includes tracking direct materials, direct labour, direct expenses, and a fair share of overheads. Since contracts are often large and complex, calculating the exact cost helps determine profitability, control waste, and maintain transparency. It ensures accurate billing and financial reporting throughout the life of the contract.

• To Determine the Profitability of the Contract

Contract costing helps in analyzing the profit or loss made on individual contracts. By comparing the revenue from certified work against total costs, businesses can measure how profitable a particular project is. This helps management evaluate the success of each contract, make informed decisions about future tenders, and refine budgeting and estimation techniques for better financial outcomes.

• To Enable Effective Cost Control

Another important objective of contract costing is cost control. It helps monitor expenses against budgeted figures and track variances at various stages. This enables the contractor to take corrective action before costs escalate. Continuous tracking of material usage, labour hours, and overheads promotes efficiency and prevents overruns, ensuring the contract is completed within the allocated budget and time.

• To Facilitate Progressive Billing and Payments

In long-term contracts, clients often pay based on the percentage of work completed or “work certified.” Contract costing provides a clear basis for raising interim bills, enabling contractors to maintain cash flow during the project. Accurate cost records are essential for issuing progressive invoices, ensuring payments are aligned with work done and helping avoid payment disputes with clients.

• To Assist in Planning and Estimation

Contract costing helps gather historical cost data that can be used for planning and estimating future contracts. By analyzing previous contracts, businesses can predict costs more accurately, prepare better tenders, and minimize the risk of underestimation or overpricing. It contributes to competitive pricing strategies and improves decision-making when bidding for similar types of projects.

• To Provide Information for Management Decision-Making

Contract costing provides valuable data for managerial decision-making, such as resource allocation, subcontractor selection, procurement planning, and workforce deployment. The data supports timely decisions about whether to continue, revise, or terminate contracts. It also helps management evaluate performance across different contracts and prioritize high-margin projects, thereby optimizing operational and financial performance.

• To Aid in Auditing and Financial Reporting

Maintaining separate accounts for each contract ensures transparency and accuracy in financial reporting. Contract costing provides verifiable records that help in internal and external audits. It ensures compliance with accounting standards, supports tax assessments, and fulfills the requirements of stakeholders such as clients, banks, or regulatory bodies. Accurate records also strengthen legal standing in case of disputes.

• To Evaluate Subcontractor and Site Efficiency

Contract costing allows the principal contractor to assess the performance of subcontractors and site personnel by comparing actual versus expected results. It helps identify delays, wastage, or inefficiencies and take corrective actions. By analyzing cost performance at different project stages, contractors can enhance site operations, improve productivity, and reduce unnecessary expenditures in future contracts.

Nature of Contract Costing:

• Project-Based and Customized

Contract costing is inherently project-specific and customized, applied to jobs tailored to client specifications. Each contract is treated as a separate unit of cost measurement. The nature of the work varies widely across contracts, depending on size, location, and scope. This customized approach ensures that the accounting accurately reflects the resources, efforts, and costs involved in completing each unique contract or project.

• Long Duration and Extended Timeline

Contracts under this costing method usually span several months or years, unlike typical manufacturing jobs. The extended nature of such contracts means that costs and revenues must be tracked over time. Because of this, expenses like depreciation, interest, and escalation costs are also considered. Interim reports, including work certified and uncertified, help track progress and calculate profits periodically before the contract concludes.

• Executed Off-Site at Client Location

Unlike manufacturing processes that happen in factories, contract work is performed on-site, such as at construction locations, shipyards, or bridges. This geographical dispersion makes contract costing unique, as it involves cost tracking for materials, labour, and overheads consumed at external project sites. Site-specific challenges like weather delays, logistics, and local regulations also affect cost accumulation and performance.

• High-Value and Capital-Intensive

Contracts are typically high-value and capital-intensive, involving significant financial investments. These may include machinery, materials, manpower, and subcontractor services. Due to their size, even small cost overruns can have a substantial impact on the profit margin. As a result, strict monitoring and control systems are integral to contract costing to ensure that budgets are followed and profitability is maintained.

• Detailed Cost Tracking

Contract costing requires granular tracking of direct costs (like materials, labour, equipment usage) and indirect costs (like site administration or shared resources). Each contract has its own account, and all expenses are recorded against it. This level of detail helps in tracking project performance, auditing, and evaluating resource utilization, which is essential for large-scale projects and for preparing client invoices.

• Revenue Recognition Over Time

Revenue in contract costing is often recognized based on the percentage of work completed, especially in long-term projects. This could be based on milestones, certifications from clients, or work progress assessments. The method of recognizing revenue gradually over time aligns accounting practices with the nature of the work, offering a more realistic view of earnings and profitability.

• Progressive Billing and Certifications

Billing in contract costing is progressive, based on the work completed and certified by the client or an architect. Work is divided into certified (approved) and uncertified (yet to be approved) stages. This progressive billing ensures continuous cash flow for the contractor and helps fund the ongoing project costs. It also necessitates accurate and up-to-date record-keeping for transparency and client confidence.

• Focus on Cost Control and Variance Analysis

Due to the high stakes involved, cost control and variance analysis are crucial in contract costing. Budgeted costs are compared with actual costs regularly to identify deviations. Corrective actions can then be taken in time to prevent losses. This also aids in making better estimates for future contracts by analyzing performance on completed contracts and identifying areas of improvement.

Types of Contract costing:

Contract costing is primarily used for large, long-term projects, and while the core principle remains the same (tracking costs per contract), it can be applied in various forms based on project characteristics, location, pricing arrangements, and payment terms.

Below are the major types of contract costing:

1. Fixed Price Contract Costing

Under this type, the total contract price is fixed at the beginning, regardless of changes in actual costs during execution.

Key Features:

• Risk is borne by the contractor.

• Profit or loss depends on how well costs are controlled.

• Escalation clauses may be included to adjust prices due to unforeseen increases in material or labour costs.

Example: A builder agrees to construct a residential complex for ₹50 crores, with no change allowed in pricing during construction.

2. Cost Plus Contract Costing

In this type, the contractor is reimbursed for actual costs incurred plus an agreed-upon percentage or fixed fee as profit.

Key Features:

• Suitable when it’s hard to estimate costs in advance.

• Low risk to contractor; more risk for the client.

• Requires detailed cost documentation and audit trails.

Example: A government agency hires a shipbuilder and agrees to pay the actual cost of materials, labour, and overheads plus a 10% profit margin.

3. Escalation Contract Costing

This type includes an escalation clause that allows the contract price to be revised if input costs (materials, wages, fuel, etc.) increase beyond a specified limit during execution.

Key Features:

• Protects the contractor from market volatility.

• Requires clear terms in the escalation clause.

• Involves complex calculations and approvals.

Example: A highway contract includes a clause that permits price revision if cement or diesel prices increase by more than 5% during the project.

4. Turnkey Contract Costing

In a turnkey contract, the contractor agrees to complete the entire project and hand it over ready for use. The client simply “turns the key” to begin operation.

Key Features:

• Contractor handles everything: design, procurement, construction, and testing.

• Payment is usually made on milestones.

• Risk is high for the contractor.

Example: A company is awarded a ₹100-crore contract to design, build, and deliver a power plant fully operational.

5. Target Cost Contract Costing

In this method, a target cost is agreed upon. If the contractor finishes below the target, savings are shared with the client; if over budget, losses are shared or borne by the contractor.

Key Features:

• Encourages cost-efficiency and collaboration.

• Risk and reward are shared.

• Requires strong cost control systems.

Example: A railway infrastructure contract includes a target cost of ₹200 crores, with a 50/50 saving or overrun share.

6. Item Rate Contract Costing

The contractor is paid based on pre-determined rates per item or unit of work, rather than a lump-sum contract value.

Key Features:

• Useful when work quantities can vary.

• Contractor is paid based on work measured and completed.

• Common in public works departments.

Example: The contractor is paid ₹1,000 per meter of road laid or ₹200 per cubic meter of earth excavated.

Procedure for Costing of Contract:

Step 1. Contract Agreement and Job Identification

The process starts with a formal contract agreement between the contractor and client. This document outlines the scope of work, estimated cost, payment terms, timeline, and deliverables. A contract number is assigned to uniquely identify and track the contract in the company’s records.

Step 2. Estimation and Budget Preparation

An estimated cost is prepared for the entire contract. This includes expected costs of materials, labour, plant, overheads, and profits. The estimate serves as a cost benchmark and is used for pricing the contract. Budgeted figures guide cost control and variance analysis throughout the execution.

Step 3. Opening of Contract Account

A separate contract account is opened in the cost books. All expenses related to that contract are recorded here. This account helps track the progress of the contract and forms the basis for profitability analysis and billing. It includes both direct and indirect costs specific to the contract.

Step 4. Procurement and Material Issue

Materials required for contract execution are either purchased specifically for the contract or drawn from stores. Material requisition slips must mention the contract number, ensuring proper cost allocation. Material returns and transfers are also recorded for accurate consumption reporting.

Step 5. Labour Cost Allocation

Workers and supervisors assigned to the contract site record their working hours using time sheets or job cards. Direct labour cost is charged directly to the contract, while indirect labour is apportioned as part of overheads. Accurate time tracking helps determine labour efficiency and control costs.

Step 6. Plant and Machinery Usage

If any plant or machinery is used at the contract site, its cost (purchase, hire, or depreciation) is charged to the contract. If shared among multiple contracts, expenses are allocated proportionally. Maintenance and fuel costs are also included under this heading.

Step 7. Overhead Allocation

Contract costing includes site overheads (site office rent, security, etc.) and a proportionate share of general overheads. These are allocated based on a logical basis, such as site labour hours or value of work done. Overheads are essential to capture the true cost of execution.

Step 8. Work Certified and Uncertified

The value of work completed is assessed periodically. Work certified is verified and approved by the client’s architect or engineer and used for billing. Work uncertified is completed work not yet approved. Both are recorded in the contract account to determine revenue and assess work-in-progress.

Step 9. Retention Money and Escalation Clause

From certified bills, a portion is retained by the client as retention money (usually 5–10%) to ensure contract obligations are fulfilled. Also, escalation clauses may allow for revisions in prices due to material or labour cost increases, and their effect is incorporated into the costing.

Step 10. Recognition of Revenue and Profit

Profits are recognized using standard methods such as:

• Percentage of Completion Method

• Proportionate Profit Based on Work Certified

The amount of profit to be taken to the Profit & Loss Account depends on the stage of completion and whether the contract is near completion.

Step 11. Contract Completion and Final Accounts

On completion, all costs and revenues are finalized. Final profit or loss is calculated and transferred to the Profit & Loss Account. The contract account is then closed after adjusting for retention money, penalties, and any other outstanding items.

Elements of Contract Costing:

• Direct Materials

Direct materials refer to all materials specifically purchased and consumed for the execution of a particular contract. These include items like cement, bricks, steel, and timber in construction contracts. The cost of these materials is directly charged to the concerned contract account. Any surplus material returned or materials transferred from or to other contracts are also adjusted, ensuring accurate material cost tracking.

• Direct Labour

This element includes the wages and salaries paid to workers who are directly involved in performing the contract work at the site. It may include masons, carpenters, welders, or technicians, depending on the nature of the contract. Their time is tracked through job cards or time sheets and charged specifically to the relevant contract. Efficient labour costing ensures productivity and helps in monitoring contract progress.

• Direct Expenses

These are the specific and identifiable costs incurred for a contract apart from materials and labour. Examples include fees for architects or engineers, hiring special equipment, or charges for permits and licenses. Since these expenses can be directly traced to a particular contract, they are posted directly to the contract account and help in establishing the complete cost profile of the job.

• Overheads

Overheads in contract costing are indirect costs incurred at the contract site or at the head office, which cannot be directly linked to a single contract. Site overheads include site office rent, security, power, and indirect labour. These are apportioned to different contracts on an equitable basis, such as direct labour hours or site usage. Accurate overhead allocation ensures fair costing and helps avoid cost distortions.

• Plant and Machinery Charges

When specific plant or machinery is used at a contract site, its cost (purchase or hire), operating costs, and depreciation are included in the contract cost. If the equipment is used exclusively for one contract, the full cost is charged. If shared, the cost is apportioned accordingly. Proper accounting for plant usage helps in managing capital costs and evaluating machinery efficiency on-site.

• Work Certified

Work certified refers to the portion of the contract work that has been completed and approved by the client’s architect or engineer. It forms the basis for interim billing and recognizing contract revenue. It is typically measured periodically and valued at the agreed contract rates. This element is essential for revenue recognition and progress tracking in long-term contracts.

• Work Uncertified

This includes work that has been completed but not yet certified by the client. It is usually valued at cost, not selling price, and represents the portion of the project that is not yet billable. While it does not generate immediate revenue, it must be accounted for to present an accurate picture of work-in-progress and to ensure that all resources used are tracked correctly.

• Retention Money

Retention money is a portion of the bill withheld by the client until the satisfactory completion of the contract or a specific maintenance period. It is generally around 5–10% of the value of work certified. While it represents future receivables, it must be noted separately in the books, as it affects the contractor’s cash flow and acts as a safeguard for quality assurance.

Advantages of Contract Costing:

• Job-Specific Cost Tracking

Contract costing allows for accurate tracking of costs incurred on each specific contract. Since each contract is treated as a separate cost unit, materials, labour, and overheads can be clearly attributed. This eliminates confusion in cost allocation, helps monitor project budgets closely, and enhances transparency. It ensures that resources are properly utilized and expenses are not misallocated between contracts or departments.

• Helps in Progress-Based Revenue Recognition

With contract costing, revenue is recognized based on work certified at different stages of the contract. This progressive billing ensures a regular cash flow and avoids revenue lumping at project completion. It benefits contractors by aligning income with costs over the duration of the project and provides clients with a transparent view of financial progress linked to physical work progress.

• Enables Profitability Analysis

Contract costing facilitates clear profit or loss determination for each contract. By comparing actual costs with contract revenue, contractors can assess which contracts are profitable and which are not. This enables management to make informed decisions, focus on more lucrative projects, and avoid loss-making contracts in the future. It also supports performance evaluation of project teams and subcontractors.

• Improves Budgetary Control

A major benefit of contract costing is that it helps in controlling costs against estimated budgets. Detailed cost records enable timely comparisons between actual and expected expenses. Variances can be identified early, allowing for corrective measures. This enhances cost efficiency, reduces wasteful spending, and increases the likelihood of completing contracts within budget and on schedule.

• Supports Better Project Planning

Contract costing provides historical data from completed projects, which is useful in planning and estimating future contracts. Management can refer to this data to prepare accurate tenders and avoid over- or under-quoting. It helps predict required resources, plan timelines, and anticipate risks. This leads to improved project feasibility assessments and better strategic decision-making.

• Enhances Accountability and Transparency

With contract costing, costs and activities are documented for each contract, enhancing accountability among project managers and site staff. It allows management and auditors to verify whether money was spent appropriately. Clear documentation improves transparency, reduces chances of fraud, and is especially useful in government and public infrastructure contracts where accountability is essential.

• Assists in Interim Billing and Cash Flow Management

Contract costing supports interim billing by accurately calculating the value of work certified and uncertified. This enables contractors to request periodic payments from clients based on completed work, improving cash flow throughout the life of the contract. It helps avoid cash crunches, ensures that resources are paid on time, and keeps the project financially stable.

• Useful for Dispute Resolution and Audits

Contract costing provides detailed records of all costs and billing activities, which is useful during audits and dispute resolution. If disagreements arise regarding payments, delays, or quality, these records serve as verifiable evidence. They also support tax calculations, client clarifications, and legal compliance. This makes contract costing a reliable system for handling large, complex contracts with confidence.

Limitations of Contract Costing:

• Complexity in Cost Allocation

One major limitation of contract costing is the difficulty in accurately allocating indirect costs like overheads, plant depreciation, and shared resources. Since multiple contracts may share facilities or staff, improper apportionment can distort contract profitability. Without clear allocation rules, true costs may be misrepresented, leading to inaccurate pricing decisions, inefficiency analysis, and profit estimations.

• Time-Consuming Record-Keeping

Contract costing requires extensive documentation of materials, labour, plant usage, and overheads for each contract separately. Maintaining these detailed records consumes time and demands significant administrative effort. Manual tracking, job cards, bills of quantities, and interim certificates can become burdensome—especially in large organizations with multiple ongoing contracts—leading to potential delays or inaccuracies in reporting.

• Unsuitable for Small Projects

Contract costing is best suited for large-scale and long-term contracts, such as construction or infrastructure projects. For small jobs or short-duration projects, it becomes inefficient and uneconomical. The administrative cost of maintaining detailed accounts for each job may outweigh the benefits. Small businesses or contractors may find simpler costing methods more suitable.

• Possibility of Cost Manipulation

Since contract costing is based on estimates, certified work values, and progress assessments, there is scope for manipulation or overstatement of costs and work done. This can happen to influence billing, show higher profitability, or cover inefficiencies. Without strong internal controls and audit checks, it may lead to financial misrepresentation or client disputes.

• Delayed Profit Recognition

In long-term contracts, profit may be deferred until substantial work is certified or until project completion. This can create challenges in financial reporting and profitability analysis during the initial phases of a contract. It may also affect investor perception and cause cash flow mismatches, particularly if clients delay certification or payments.

• Difficulty in Estimating Future Costs

At the start of a contract, estimating future costs for labour, materials, and plant can be challenging, especially for projects spanning years. Unexpected price hikes, labour shortages, or weather disruptions can increase costs drastically. Such variances can lead to reduced profit margins or even losses, especially in fixed-price contracts where adjustments are limited.

• Dependent on External Certification

Contract costing relies heavily on external agencies for certification of completed work. Delays or disputes with clients’ architects or engineers can halt billing and affect cash flow. The contractor’s accounting and cost tracking depend on the timely approval of work certified, making the system vulnerable to procedural delays or subjective assessments.

• Requires Skilled Personnel and Technology

Implementing contract costing effectively requires trained personnel and reliable software systems to track costs, progress, and billing. Without proper skills and tools, errors may occur in estimating, recording, and analyzing contract data. Small firms may struggle to adopt modern contract costing techniques, leading to poor cost control and inefficient operations.

Industries Where Contract Costing Can be Suitably Applied:

Contract costing is commonly used in industries where each project has a unique scope of work and requires a specific set of resources to complete. Some of the industries where contract costing can be suitably applied include:

• Construction industry: Contract costing is widely used in the construction industry to determine the cost of building projects such as houses, office buildings, bridges, and highways. Each project has a unique scope of work and requires a specific set of resources to complete, making contract costing an effective method of cost accounting in this industry.
• Engineering industry: Contract costing is commonly used in the engineering industry to determine the cost of designing and building complex machinery or equipment. Each project is unique and requires a specific set of skills and resources to complete, making contract costing an effective method of cost accounting in this industry.
• Software development industry: Contract costing is used in the software development industry to determine the cost of developing custom software applications for clients. Each project has a unique set of requirements and specifications, making contract costing an effective method of cost accounting in this industry.
• Film and entertainment industry: Contract costing is used in the film and entertainment industry to determine the cost of producing movies, television shows, and other forms of entertainment. Each project has a unique set of requirements and resources, making contract costing an effective method of cost accounting in this industry.
• Shipbuilding industry: Contract costing is used in the shipbuilding industry to determine the cost of designing and building ships. Each ship is unique and requires a specific set of resources and skills to complete, making contract costing an effective method of cost accounting in this industry.

Profit and Loss on Incomplete Contracts:

Profit and loss on incomplete contracts refer to the calculation of profits or losses on contracts that are in progress but not yet completed. This is important for contract costing because it allows companies to determine the financial status of ongoing projects and to take corrective action if necessary.

The profit and loss on incomplete contracts can be calculated in different ways, depending on the method used for contract costing. One common method is the percentage of completion method, which involves estimating the percentage of work completed on a contract and applying that percentage to the total cost of the project.

To calculate the profit or loss on an incomplete contract using the percentage of completion method, the following steps are typically taken:

• Determine the total contract price and the total estimated cost of the project.
• Estimate the percentage of work completed on the project based on the amount of work done to date.
• Multiply the estimated percentage of completion by the total estimated cost of the project to determine the estimated cost of work completed.
• Subtract the estimated cost of work completed from the total contract price to determine the estimated gross profit or loss on the project.
• Compare the estimated gross profit or loss to the actual costs incurred to date to determine the actual profit or loss on the project.

If the estimated profit or loss on an incomplete contract is unfavorable, corrective action may need to be taken to bring the project back on track. This could include renegotiating the contract terms, increasing efficiency to reduce costs, or increasing the selling price of the project if possible.

Example

In this example, the contract account shows the various costs and revenues related to a contract. The contract price is credited to the account at the start of the contract, and the costs are debited to the account as they are incurred. Work certified, materials issued, direct wages, and direct expenses are all direct costs of the contract, while the balance carried down represents the value of work done but not yet certified.

In the second half of the table, the balance brought down is carried forward, and additional costs and revenues are recorded. Work uncertified represents work that has been done but not yet certified, while materials returned, direct wages, and direct expenses represent adjustments to the direct costs. Finally, the profit transferred represents the profit earned on the contract, which is transferred to the profit and loss account. The balance carried forward represents the final profit on the contract.