Contract Costing Meaning
Contract Costing is a contract made between two parties known as a contractor (i.e., the person executing the job) and contractee (i.e., the person for whom the job is done), wherein specific job orders are undertaken for a relatively larger time frame, which may take years to complete, and the billing for the same is done after completion of each milestone in the contract.
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For eg:
Source: Contract Costing (wallstreetmojo.com)
Features of Contract Costing
- Due to a larger time frame (taking more than one year for completion) involved in each contract, the contractor undertakes a smaller quantum of contracts during the year.
- The execution of work is required at the work-site.
- Each customer has a separate account maintained to track work done, progress billings & amounts received to date.
- Direct expenses include the cost of material, labor, electricity, telephone charges, insurance expensesInsurance ExpensesInsurance Expense, also called Insurance Premium, is the amount a Company pays to obtain an insurance contract for covering their risk from any unexpected catastrophe. You can calculate it as a fixed percentage of the sum insured & it is paid at a daily pre-specified period. read more, consumables, depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more, or hire charges of machinery used for the contract.
- The progress-billings are decided by the certificate from experts, wherein work completion is specified. The proportionate billing is done accordingly.
- It also has a special aspect of retention money given by customers to contractors after examining the quality of the overall contract.
- There is also a penalty clause in a few contracts, which is to be paid by the contractor to the customer if he cannot complete the contract within the time frame.
- Each contract is executed as per the customer’s customization or specifications, and hence, each contract is different.
- It’s not the cost of material & labor involved in the contract is relevant, but the work completed to date is relevant.
- Substantial risk is involved in the contracts.
Example of Contract Costing
Let’s have following details for calculation purpose –
Solution
Explanation
- All costs incurredCosts IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. read more to date have been considered. The amount of expenses yet to be incurred is added to arrive at the total estimated cost.
- From an accounting point of view, we are more concerned with the total estimated cost. This is compared with the contract price to arrive at the estimated profit for the year.
- Revenue is recognized based on the degree of completion, as specified by the expert. Using the revenue & estimated total cost, we have arrived at a notional profit from the contract.
- Using the revenue figure, we calculated further billing to be made to the contractor.
Types of Contract Costing
The three types of contracts are explained further –
Specific Aspects of Contract Costing
There are specific terms associated with contract costing that is usually helpful in calculating the cost involved in the contract:
- Work-in-progress is an important aspect of contract costing. This refers to the amount of pending work & not yet completed as on a specific date. In the balance sheet, the cost of completed & certified (by the expert) and the amount of profit earned in presented under the head “Certified Work-in-progress.” Also, the value of uncertified work includes the cost of work not yet certified, the cost of laborCost Of LaborCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.read more, material, and other expenses connected with the contract.
- The cost of certified work is decided as per the milestones set in the contract. Thus, experts such as architects, engineers, surveyors, etc. are appointed to certify the work completed to date. As per the work completion, the revenue is recognized by the contractor.
- As per the work completion criteria, the contractor is set to receive the progress payments from the customer. The contract longs for a considerable period & the working capital is invested in the contract by the contractor. Thus, it is always suggested to have the policy of progress payments.
- The contractee/customer keeps some amount of money with himself as retention money (or security deposit), ensuring that the work is carried out as per the plan decided in the contract & the end work is defect free. The amount is used to settle any discrepancies between the two parties.
- Profits are estimated at two stages. One at the time when work certified by the contractor, it is called as notional profit. After completion of the whole contract, the actual profit is calculated.
Advantages
- The contractor controls the costs involved in the contract for labor, material, other fixed expenses, etc.
- A contract account is prepared for each customer, identifying the cost incurred to date & work completion.
- Control is also maintained over the defectives arising out of quality deficiency.
- Expert advice is helpless in completing a contract & he also helps to identify defects before completion of the whole contract.
- Retention money becomes a reason for inspiration to provide quality work.
- A team spirit is built.
Disadvantages
- The biggest disadvantage is that it is time-consuming.
- Each customer may not agree with the escalation clause.
- Lack of accounting may lead to improper calculation of profits.
- Lack of control may make the contract loss-making for the contractor.
- A continuous eye on market conditions is required.
- Larger time gives rise to complications in the completion of work.
Recommended Articles
This has been a guide to Contract Costing and its meaning. Here we discuss features, types of contract costing, and an example, importance, advantages, disadvantages, and differences. You can learn more about financial analysis from the following articles –
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