Contract Costing, Nature, Objectives, Procedure, Elements, Types, Example

Contract costing is a method of cost accounting that is used to determine the cost of producing goods or services under a specific contract or job. This method of costing is typically used by companies that engage in projects that are unique, custom-made, and have a specific scope of work. Examples of industries that commonly use contract costing include construction, engineering, and software development.

Under contract costing, the cost of a contract is determined by identifying and accumulating all the direct costs and indirect costs that are directly associated with that contract. Direct costs are those costs that can be directly attributed to the specific contract, such as labor, materials, and equipment. Indirect costs are those costs that are necessary for the contract to be completed, but cannot be directly attributed to it, such as overheads and administrative expenses.

The cost of the contract is typically divided into stages or phases, and costs are accumulated and recorded against each stage. The cost of each stage is then used to calculate the progress of the project and to prepare invoices for the customer.

At the end of the project, the total cost of the contract is calculated by adding up all the direct and indirect costs incurred during the project, and any adjustments for under or over-recovery of overheads are made. The final cost of the contract is then compared to the original estimated cost to determine the profitability of the project.

Here are different definitions of contract costing:

“Contract costing is a costing method used to determine the cost of producing goods or services under a specific contract or job. It involves identifying and accumulating all the direct and indirect costs associated with a specific contract, and then dividing the cost into stages or phases to monitor the progress of the project.”

“Contract costing is a method of cost accounting that is used to determine the cost of producing custom-made goods or services that are specific to a particular contract or project. This method of costing is used in industries such as construction, engineering, and software development, where each project has a unique scope of work and requires a specific set of resources to complete.”

“Contract costing is a system of accounting that is used to determine the cost of a specific contract or job. It involves recording and accumulating all the costs associated with the contract, including direct and indirect costs, and then using this information to calculate the profit or loss on the contract.”

“Contract costing is a method of determining the cost of producing a specific product or service that is unique to a particular contract or project. It involves the identification and accumulation of all the costs associated with the project, including materials, labor, overheads, and any other direct or indirect costs.”

Nature of Contract Costing

• Custom-made products or services: Contract costing is used to determine the cost of producing custom-made goods or services that are specific to a particular contract or project. This means that each contract is unique and requires a specific set of resources to complete.
• Direct and indirect costs: Contract costing involves identifying and accumulating all the direct and indirect costs associated with a specific contract. Direct costs are those costs that can be directly attributed to the contract, such as labor and materials. Indirect costs are those costs that are necessary for the contract to be completed, but cannot be directly attributed to it, such as overheads and administrative expenses.
• Cost divided into stages or phases: The cost of each contract is divided into stages or phases to monitor the progress of the project. Costs are accumulated and recorded against each stage, and the cost of each stage is used to calculate the progress of the project and to prepare invoices for the customer.
• Profitability: Contract costing is used to determine the profitability of each contract. At the end of the project, the total cost of the contract is compared to the original estimated cost to determine the profit or loss on the contract.
• Used in specific industries: Contract costing is commonly used in industries such as construction, engineering, and software development, where each project has a unique scope of work and requires a specific set of resources to complete.

Objectives of Contract Costing

• To determine the actual cost of each contract: The primary objective of contract costing is to determine the actual cost of producing goods or services under a specific contract. This involves identifying and accumulating all the direct and indirect costs associated with the contract.
• To determine the profitability of each contract: Contract costing is used to determine the profitability of each contract. By comparing the actual cost of the contract to the estimated cost, management can determine whether the contract was profitable or not.
• To determine the progress of each contract: Contract costing involves dividing the cost of each contract into stages or phases. This allows management to monitor the progress of the contract and to identify any issues or delays that may impact the completion of the project.
• To prepare accurate invoices: The cost of each contract is recorded and accumulated against each stage or phase. This information is used to prepare accurate invoices for the customer, based on the work completed and the costs incurred to date.
• To improve cost control: Contract costing provides management with detailed information about the costs associated with each contract. This allows them to identify areas where costs can be reduced and to improve cost control in future contracts.

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.

Procedure for Costing of Contract

The procedure for costing of contract involves the following steps:

• Preparation of contract budget: The first step in the costing of a contract is to prepare a budget for the contract. This involves estimating the cost of all the resources required to complete the project, including direct costs such as labor and materials, as well as indirect costs such as overhead expenses.
• Identification of cost centers: Once the budget has been prepared, the next step is to identify the cost centers that will be used to accumulate the costs associated with the contract. These cost centers will typically correspond to the different stages or phases of the project.
• Accumulation of costs: The costs associated with the contract are then accumulated in the appropriate cost centers. This involves recording all direct and indirect costs associated with the contract, including labor, materials, equipment, and overhead expenses.
• Allocation of indirect costs: Once the costs have been accumulated, the indirect costs are allocated to the different cost centers based on an appropriate allocation method. This may involve allocating overhead expenses based on the amount of labor or materials used in each cost center, for example.
• Calculation of cost per unit: Once all the costs have been accumulated and allocated, the cost per unit of output is calculated. This involves dividing the total cost of the contract by the number of units produced or the amount of work completed.
• Analysis of costs: The final step in the costing of a contract is to analyze the costs and compare them to the budgeted costs. This allows management to identify any areas where costs have exceeded the budget and take corrective action if necessary.

Types of Contract costing

There are two main types of contract costing:

• Single Contract Costing: Single contract costing is used when a company undertakes a single contract or project, which is usually large and complex. In this method, the costs are accumulated and allocated to the specific contract, and the profit or loss for the contract is determined once the project is completed. The cost centers are established for each contract, and the indirect costs are allocated to each cost center based on an appropriate allocation method.
• Multiple Contract Costing: Multiple contract costing is used when a company undertakes several contracts simultaneously or consecutively, which may be similar or different in nature. In this method, the costs are accumulated and allocated to each contract separately, and the profit or loss for each contract is determined independently. The cost centers are established for each contract, and the indirect costs are allocated to each cost center based on an appropriate allocation method.

Both types of contract costing have their own advantages and disadvantages, and the choice of method depends on the nature of the business and the projects undertaken. Single contract costing is suitable for companies that undertake large and complex projects, whereas multiple contract costing is suitable for companies that undertake several contracts simultaneously or consecutively.

Elements of Contract Costing

The main elements of contract costing include:

• Direct Materials: The cost of all materials that are directly used in the construction or production of the project are included in this element. This includes the cost of raw materials, components, and parts.
• Direct Labor: The cost of all labor that is directly involved in the construction or production of the project is included in this element. This includes wages, salaries, and benefits of workers who are directly involved in the project.
• Direct Expenses: This includes all expenses that are directly related to the project, such as transportation, subcontracting, and equipment rental.
• Indirect Materials: This includes the cost of all materials that are not directly used in the construction or production of the project, but are necessary to support the project. This includes items such as office supplies, tools, and equipment.
• Indirect Labor: This includes the cost of all labor that is not directly involved in the construction or production of the project, but is necessary to support the project. This includes wages, salaries, and benefits of workers who are not directly involved in the project, but are necessary to support the project.
• Indirect Expenses: This includes all expenses that are not directly related to the project, but are necessary to support the project. This includes items such as rent, utilities, and insurance.
• Profit: This includes the expected profit margin for the project, which is typically expressed as a percentage of the total cost of the project.

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.