This article is written by Jaya Vats, a practising advocate, Delhi. In this article, the author discusses a detailed study on all the aspects related to contract costing. The article provides an in-depth analysis of the meaning, objectives, nature, features, types, procedures, advantages and disadvantages of contract costing.
It has been published by Rachit Garg.
Contract costing is a costing approach used in a firm when non-repetitive contracts are executed on a regular basis. It is a type of particular order costing approach that is used for a project that lasts more than a year and is typically completed on the contractee’s preferred site. It is a contract between two parties known as a contractor (i.e., the person executing the job) and a contractee (i.e., the person for whom the job is done). Here, specific job orders are undertaken for a relatively long time frame, which may take years to complete, and billing is done after the completion of each milestone in the contract.
What is the contract costing
The phrase ‘contract costing,’ according to CIMA (Chartered Institute of Management Accountants), refers to “a type of particular order costing that applies when work is performed to the customer’s unique specifications and each order is of extended duration” (compared with those to which job costing applies). Contract costing is a particular order costing that applies if work is conducted to the customer’s special requirements and each order is of extended duration.
The task is often construction-related, and the process is comparable to job costing in general. As a result, it is a subset of job costing in which the unit of cost is a single contract and distinct identifying numbers are assigned to each contract in order to collect cost. However, contract costing is a method of job costing where a contract serves as a cost unit. The concepts of job costing apply to contract costing and are based on the same cost-determination basics. It is similar to manufacturing job costing, but the main difference is that the contract is for a longer period of time. Contract costing is less detailed and easier to understand than job costing.
Contract industries where contract costing can be suitably applied
Contract costing is appropriate for use in –
- Ready-made clothes;
- The healthcare industry;
- Industries of manufacture;
- Businesses involved in the construction of buildings, roads, ships, dams, boiler houses, bridges, and other structures;
- Engineering companies, civil engineering firms, and mechanical engineering firms;
Contractors involved in railway line projects are public works contractors.
Examples of contact costing
There must be two main parties engaged in contract costing: the contractor (who completes the task) and the contractee (who receives the completed task). The cost unit in contract costing is the contract itself. Contracts are often finalised at the workplace by the contractor.
Let’s look at a simple example of a cost-plus contract. Assume Infra Constructions is awarded a contract to build a building, and the following terms are agreed upon. Infra Constructions will be compensated for the total cost of the project (estimated at $ 25 million). Profits will be 20% of the total cost of a project, up to a maximum of $ 5 million. If the project is finished within 12 months, a $ 0.5 million incentive fee will be paid.
Infra Construction successfully completed the project in eleven months and so qualified for the $ 0.5 million additional bonus.
The entire cost expended was $ 20 million, which included direct labour costs, material costs, and project overhead. The contractee received the necessary documentation, such as bills, work hours on a project, and labour cost. As a result, the contractor’s total revenue will be = $ 20 million * 20% = $ 4 million + $ 0.5 million = $ 4.5 million.
Objectives of contract costing
Contract costing has four primary goals, which are as follows:
- Actual and expected prices are compared.
- A thorough cost evaluation is performed in order to establish a foundation for cost-plus pricing.
- Profit calculation for a long-term contract that may be taken every year.
- Management assistance in resource allocation.
Nature of contract costing
Contract costing is a kind of particular order costing that is commonly used in industries wherein work is being performed to meet the special demand of the customer and each order is of extended duration, including construction, shipbuilding, superstructure for bridge, civil infrastructure, and so forth. Typically, the task is performed outside of the facility.
Increased proportion of direct cost
Many costs that are generally regarded as indirect costs may exist. Because most site activities are self-contained, these may be traced back to a contract. As a result, they can be charged directly, for example, telephone established on-site, site electricity use, site cars, transportation, wage bill (of site labour), supervisory staff compensation, and plant cost (exclusively purchased for a particular contract).
Low indirect costs
In most contracts, the principal indirect cost component is a fee for head office expenditures. Other indirect expenses include the wages of workers who are not associated with a specific contract or the compensation of supervisory personnel who oversee two or more contracts.
Cost control difficulties
The contract’s scope and magnitude provide significant challenges to cost control. These issues are common and involve material consumption and inefficiencies, embezzlement, labour supervision and utilisation, and plant and equipment damage and loss.
A contract’s supplies are invoiced directly to the contract. The cost of materials not utilised is credited to the contract account at the end of the contract, and if they were transferred immediately to another contract, the new contract account is deducted. If the materials are not required immediately, they must be held and the amount deducted from a stock account.
Features of contract costing
Contract Costing has the following key features:
- Parties involved: A contract has two parties: (a) a contractor who engages and performs work underneath a contract, and (b) a contractee for whom the work is conducted.
- Cost unit and cost centre: The contract, for example, is the cost centre (location) and cost unit (output) in contract costing.
- Site work: The majority of the work in each contract is often completed at the contract’s location.
- Indirect costs: Indirect expenditures, such as administrative office expenses and common expenses, are allocated to various contracts on an as-needed basis. Depreciation of common equipment used on many contracts, for example, is allocated based on the number of days the equipment has been utilised on multiple contracts.
- Penalty clause: In a few contracts, there is also a penalty clause that requires the contractor to pay the customers if the contract is not completed within the time range.
- Separate accounts: For each deal, a separate account is kept to determine profit or loss. Each client has their own account, which is used to keep track of services completed, advance billings, and funds collected till date.
- Customer-oriented: Every contract is unique since it is completed in accordance with the customer’s modifications or requirements.
- Expenses incurred directly: The majority of the contractor’s expenditures are directly related to the site.
- Profit recognition: A contract normally takes a long time to complete. Earnings recognition after contract completion may result in large changes in profit year after year.
To minimise these variations, earnings are often recognised annually based on the percentage of finalisation and the sum of national profit.
When does the method of contract costing come into play
Contract costing is a costing approach used in businesses when individual non-repetitive contracts are conducted. It is a type of individual order pricing in which work is performed in accordance with the customer’s special requirements and each order is lengthy. It is commonly used by contractors who work on construction and engineering projects such as roads, dams, buildings, canals, railway lines, bridges, city or town drainage systems, hospitals, schools, or colleges buildings or private structures, shipbuilding, and so on. In general, the contract is carried out at the location as mentioned by the customer, and in accordance with the client’s specifications. Furthermore, the time required to finish a contract is typically more than a year. The major goal of generating contract accounts is to determine the cost of each contract separately as well as the profitability of each contract.
Facets of contract costing
The following are the major characteristics of contract costing:
- Such contracts are often carried out at a contract site that is separate from the contractor’s premises.
- These contracts are executed on a large-scale that may span many accounting periods.
- For cost determination, each contract is regarded as a single unit of cost.
- More frequently than not, one contract varies from the others.
- Contracts are carried out in accordance with the requirements specified by the contractee.
- Because the work is done at the contract site, the majority of the expenses will be direct.
- The contract is carried out by the contractor for an agreed-upon sum of money termed as the contract price.
- The contractee pays the contractor in instalments based on the amount of work accomplished and confirmed as complete by the contractee’s architect or engineer.
- The contractor is expected to pay a penalty if the contract is not completed within the specified time frame.
- The contract may include an ‘escalation term,’ which compensates the contractor for increased costs based on inflation.
The escalation clause is generally included in a contract agreement because the contractor wants to be protected from any price increases. To avoid any conflicts, the agreement describes the mechanism for calculating adjustments. To protect both the contractor and the contractee from risks, the contract can also include an escalation provision that allows for a modification in the contract price owing to a change in the usage of means of production above an agreed-upon threshold. To put it another way, this is a clause in the contract that protects the contract’s price from fluctuations in the price of labour and materials, as well as changes in the usage of production components. The purpose of this provision is to protect both parties’ interests from adverse price fluctuations. As a result, under a contract with the transportation enterprise, the cost per ton-mile will grow or dip by 10% of the current market price for any increase or drop in the value of the fuel. In this case, the contractor must provide adequate documentation of extra expenditures before the consumer is willing to refund such charges. Furthermore, the contract specifies the justification for the price level.
If indeed the escalation clause gets expanded to include greater intake or usage of quantities of goods or manpower, the contractor must satisfy the contractee that the increasing usage is not the result of his inefficiencies. This clause will also provide that if prices come down under a predetermined threshold, the contractee is subjected to a reimbursement. It is known as the de-escalation clause.
The impact of an escalation clause
Inflationary price increases are a frequent occurrence in the present era. A contract often takes longer to fulfil, and the price of materials, labour, and the plant may rise over a certain threshold during this time. In such a circumstance, the provision known as the escalation clause protects both the contractor and the contractee’s interests against future unfavourable price adjustments.
The contractee is required to absorb the higher costs resulting from such escalation under this provision. A similar condition may also apply when material and labour use surpasses a certain threshold. A de-escalation or reverse clause, which provides for a drop in the contract price and passes the advantage on to the contractee, is common.
Types of contract costing
Contracts are classified into two types:
- Contracts with a fixed price
The price is normally determined and decided beforehand in this form of transaction. Tenders are typically requested to provide contract specifics in order to determine the contract price. Any further work may be invoiced individually according to the parties’ understanding. For example, there may be a clause in the contract that allows the contractor to pass on increased expenses incurred as a result of material price increases or pay awards.
- Fixed cost contract with escalation cost
The FPE contract is a fixed-price contract with an escalation clause designed to deal with the economic risks that come with long-term, fixed-price remuneration. This contract allows for the upward and downward adjustment of the specified contract price in the event of certain economic situations, which are clearly outlined in the escalation clause. Its purpose is to shield the administration and the contractor from the consequences of volatile market circumstances.
Contractors might be expected to include contingency provisions in their bids or proposals if such clauses were not utilised to remove or decrease the risk of loss. The risk associated with this option is serious. If the contingency exceeds the contractor’s estimate, the contractor may be harmed, and the government may be forced to pay exorbitant charges if the contingency does not materialise.
For example, a clause in a contract states that the rent will be increased on a regular basis if the cost of living index rises. Alternatively, changes in the economy induce a period of inflation in which the costs of raw materials required to make products or services rise over a specific threshold. The presence of an escalation clause benefits both the consumer and the firm that provides the customer with products. The clause allows the firm to avoid circumstances in which goods or services must be given to the client at a loss when a change in the economy raises the cost of raw materials or other costs that are necessary to the manufacturing process.
The client gains because offering a mechanism for price rises under particular conditions implies that there is less likely to be an interruption in the delivery of those contractual items, allowing the consumer to utilise those products in whatever manner is deemed beneficial.
- Contracts with a cost-plus clause
A cost-plus clause contract is the complete antithesis of a fixed price contract. A cost-plus contract is one in which the price is not agreed upon in advance for various reasons. This form of contract is used when it is hard to determine future price or cost with adequate precision due to a lack of historical records and experience or unusual situations, such as the drilling of an oil well.
Later, the contract price is determined by adding a predetermined percentage of profit to the overall contract cost. The many categories of spending to be considered in determining the contract’s cost are agreed upon in advance.
In general, the contract provides the items of expenditure to be included in the real cost as well as the proportion of profit to be added to the actual cost. This form of contract is appropriate when the contract’s expected cost cannot be calculated with an acceptable degree of precision in advance for a variety of reasons. Dams, bridges, power plants, aviation, and other government contracts are often cost plus. The contract’s records and documentation must continue to operate for customers to view and authenticate. Cost-plus contracts offer various benefits and drawbacks for both contracting parties.
The majority of the expenditures in contract costing are basic in structure, such as materials, labour, expenses, plant, sub-contract charges, and so on. Only a small fraction of the total is levied as overhead, which is allocated appropriately. The fundamental approach for contract pricing is as follows:
- Contract account: Every contract is assigned a unique number, and a different account is established for every contract.
- Direct costs: The majority of a contract’s costs may be directly attributed towards the contract. All direct charges of this nature are charged to the contract account. Contract direct costs involve:
- Labour and supervision,
- Direct expenses,
- Plant and machinery depreciation, and
- Subcontract costs.
The cost of materials utilised is deducted from the contract account. Materials may be acquired explicitly on the open market, issued from retailers, transferred from previous contracts, or supplied by the contractee himself. The value of materials returned to retailers is credited to the contract account in question. Materials may be moved from one contract to another at times. If this is the case, the amount of the materials is deducted from the recipient contract account and reimbursed from the transferring contract account.
In general, the contract is performed exclusively at the contractee, i.e., the customer’s location, rather than within the company’s facilities. As a result, labour is hired on the job site to complete the contract.
Direct expenditures are deducted from the relevant contract account when they are incurred. Hire costs for the outside plant, subcontractor’s costs, architect’s expenses, power, security, and other direct costs are examples of direct expenses.
Subcontract work is often provided as part of a contract, and payments paid on subcontract work are credited to the Contract Account. The contractor (if permitted by the contract) may delegate a portion of the project to one or more subcontractors (s). The cost in this case is a direct charge on the contract and is accounted for as such in the contract costing.
- Indirect expenses: The contract account is also deducted for overhead expenses, which are often little in comparison to direct costs. Such expenses are frequently incorporated in an arbitrary manner, such as a proportion of the prime cost, materials, labour, and so on. Expenses are often limited to head administrative and storage expenses.
- Transfer of materials or plant: When supplies, plants, or other commodities are moved from a contract, that value is credited to the contract account.
- Contract price: The contract price too is deposited into the contract account. If an agreement is not completed before the end of the fiscal year, the contract account is debited with the value of the work as of that deadline.
- Contract profit or loss: The balance of the contract account indicates profit or loss, which is moved to the financial statement i.e, the profit and loss account. However, if the contract is not finished during the fiscal year, only a portion of the profit is considered, and the remainder is maintained as a reserve to pay any potential loss on the incomplete component of the contract.
The benefits and drawbacks of contract costing
- The contractor is in charge of the contract’s costs for labour, materials, other fixed charges, and so on.
- Each customer receives a contract account that details the costs expended to date and the work completed.
- Control is also maintained over defects caused by a lack of quality.
- Expert assistance is useless in finishing a contract, and he also assists in identifying faults before the execution of the entire contract.
- Retention money becomes a source of motivation to produce high-quality work.
- A sense of belonging is fostered.
- The main drawback is that it takes time.
- The escalation clause may not be acceptable to every customer.
- Profits may be calculated incorrectly due to a lack of bookkeeping.
- Lack of control may result in the contractor incurring a loss on the contract.
- It is necessary to keep an eye on market circumstances at all times.
- Increased time causes challenges in the execution of tasks.
Distinction between contract costing, terminal costing, and job costing
When it comes to the nature of the business, contract costing, job costing, and terminal costing are all similar. Contract costing varies from job costing in that a contract is completed at a location outside the contractor’s factory, while in the case of job costing the work is completed within the contractor’s foundry.
Furthermore, determining the value of a contract is simpler than comparing the value of a work. A contract is completed outside the manufacturing grounds, and therefore, the majority of the expenditures spent by the contractor in the implementation are direct.
A task is conducted within the manufacturing site and includes the completion of multiple jobs at the same time; indirect expenditures must be allocated to these tasks on an equal basis.
Since terminal costing requires a timeframe specified by the contractee upon which a task or contract must be performed, contract costing and job costing differ from terminal costing.
In the event of a predefined time frame, the contractor must compensate the contractee for any losses incurred as a result of the postponement in accomplishing the assignment or contract.
With the rising variations in industries as well as the intricacies of enterprises, costing is becoming increasingly necessary for management in order to make reasonable decisions, coordinate and manage, and have efficient cost management methods in place.
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