Contract costing is a specific method of cost accounting used by businesses that undertake large-scale, long-duration projects, which are typically performed at a customer’s site. This method is used to track and ascertain the cost and profitability of each individual project or ‘contract’ separately. It is a variant of job costing and is widely used in the construction, shipbuilding, and engineering industries.
The Purpose and Objectives of Contract Costing
The primary objective of contract costing is to determine the total cost incurred on a specific contract and, consequently, the profit or loss made from it. Since these contracts often span multiple accounting years, contract costing also provides a mechanism for recognizing a portion of the profit on incomplete contracts at the end of each financial year.
Key objectives include:
- To track all costs (materials, labor, overheads) specifically associated with each contract.
- To calculate the total cost of a contract upon its completion.
- To determine the profit or loss on each individual contract.
- To provide a basis for billing the client at various stages of completion.
- To help in controlling costs and improving efficiency for future contracts.
Key Features of Contract Costing
Contract costing is used for jobs that have specific, identifiable characteristics.
- Unique Contracts: Each contract is a distinct, cost-able unit.
- Long Duration: The work is of a long duration, typically lasting for more than one year.
- Work at Site: The work is executed at the client’s site, away from the contractor’s premises.
- High Value: The contracts are generally of a high value.
- Direct Costs are Dominant: Most costs, such as materials and labor, can be directly identified and charged to a specific contract.
- Progress Payments: The client (contractee) usually makes payments in installments based on the stage of completion of the work, which is certified by an architect or surveyor.
The Contract Costing Procedure
To track the costs and profits of each project, a separate ‘Contract Account’ is prepared for each contract.
- Recording Costs: All direct costs related to the contract (materials issued to the site, wages paid to workers on site, other direct expenses) are debited to the Contract Account. Indirect costs (overheads) are also apportioned and debited.
- Work Certification: Periodically, the contractor asks the client’s architect to inspect the work done. The architect then issues a certificate stating the value of the work completed so far. This is called ‘Work Certified’.
- Progress Payments: The client pays a percentage of the work certified (e.g., 80% or 90%) to the contractor. The amount withheld by the client is known as ‘Retention Money’.
- Profit on Incomplete Contracts: At the end of the accounting year, if a contract is not yet complete, the contractor may recognize a notional (estimated) profit. The amount of profit to be recognized depends on the stage of completion of the contract.
| Industry | Example of a Contract |
|---|---|
| Construction | Construction of a building, bridge, or road. |
| Shipbuilding | Building a new ship or a submarine. |
| Heavy Engineering | Erection of a power plant or a large boiler. |
| Civil Engineering | Construction of a dam or a canal. |
Contract costing is a crucial method for project-based businesses to manage their finances effectively. It is a core topic in cost accounting studies, just like understanding PV ratio or departmental accounting. It provides the financial framework for managing large-scale projects from start to finish.
Frequently Asked Questions (FAQs)
What is contract costing?
Contract costing is a method of cost accounting used to determine the cost and profit of a specific, large-scale, long-term project or ‘contract’. It is used by industries like construction and shipbuilding where each project is a separate cost unit.
What is the main objective of contract costing?
The main objective is to track all the costs associated with a particular contract and calculate the final profit or loss on that contract. It also helps in recognizing a portion of the profit on contracts that are still in progress at the end of a financial year.
What is a Contract Account?
A Contract Account is a nominal account prepared in the books of the contractor for each individual contract. All expenses related to the contract are debited to this account, and the contract price is credited upon completion. The balance of the account shows the profit or loss on the contract.
What is ‘Work Certified’ in contract costing?
‘Work Certified’ is the value of the work completed on a contract that has been approved and certified by an independent architect or surveyor hired by the client. Progress payments from the client to the contractor are based on this certified value.
What is ‘Retention Money’?
Retention money is a portion of the value of work certified that is withheld by the client (contractee) and not paid to the contractor immediately. It is held as a security deposit to ensure that the contractor completes the work satisfactorily and rectifies any defects that may appear later.