CONTRACT

COSTING
• KARTHIK R VARMA
• ANU SHAMIL
• SANDRA C B
• GETHIN MATHEW GEORGE
WHAT IS CONTRACT COSTING?
• Contract costing is a form of particular order costing that contractors
generally apply for orders of a long duration. However, some prefer
calling it "terminal costing" because after completing the work, the
account is closed immediately.
• As this name implies, contract costing is a process of tracking costs that
are associated with a specific contract. Hence, this can be a specialised
form of job costing. Nevertheless, this system only applies to jobs which
include a contractual bond

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OBJECTIVES
• Find a comparison between the actual cost with an estimated cost
• Analyse cost to provide a basis for cost-plus pricing
• Calculate profit over the long-term contract
• Guidance for managing resource utilisation

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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.
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INDUSTRIES THAT USES CONTRACT COSTING
Construction Industry: Construction companies often use contract costing to
determine the cost of construction projects, which can vary significantly based
on the project specifications, materials used, labor costs, and other variables.
Shipbuilding Industry: Shipbuilding companies use contract costing to
calculate the costs associated with building specific ships. Each ship project can
be unique, requiring different materials and labor, making contract costing
essential for accurate cost assessment.
Aerospace Industry: Aerospace companies utilize contract costing for building
aircraft and spacecraft. Similar to shipbuilding, each aircraft or spacecraft
project can have distinct requirements, leading to variations in costs.
Engineering Firms: Engineering companies that undertake customized
engineering projects for clients, such as designing bridges, dams, or other
structures, use contract costing to determine project-specific costs.
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Software Development Industry: Companies engaged in custom software
development often use contract costing to estimate the costs associated with
developing specific software applications tailored to a client's needs.
Event Management Industry: Event management companies use contract costing to
calculate the costs related to organizing events, conferences, or exhibitions, taking into
account various elements like venue, catering, decorations, and entertainment, which
can vary for each event.
Film and Entertainment Industry: Film production companies and other
entertainment-related businesses use contract costing to manage costs associated with
producing movies, TV shows, or theatrical productions, considering expenses like cast
and crew salaries, special effects, location costs, and post-production expenses.
Architectural Firms: Architectural firms working on customized projects, such as
designing specific buildings or structures according to client requirements, use
contract costing to determine project-specific costs.
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Oil and Gas Industry: Companies involved in constructing pipelines,
refineries, or other oil and gas infrastructure projects use contract costing
to calculate project costs, considering factors like materials, labor, and
safety regulations.
Defense Contractors: Companies involved in producing defense
equipment, weaponry, and military technology use contract costing to
estimate the costs of manufacturing specific defense systems tailored to
military requirements.
• These are just a few examples, and contract costing can be applied in
various other industries where customized products or services are
provided to clients on a project-by-project basis.

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TYPES OF CONTRACT COSTING
• FIXED PRICE CONTRACT
• CONTRACTS WITH ESCALATION CLAUSE
• COST PLUS CONTRACTS

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FIXED PRICE CONTRACTS
• A contractor and a contractee agree upon a fixed price in
this type of contract. Then, after the completion of that
job, a project owner or a customer pays that amount to a
contractor.
• If there are any defects in the work, the contractor is
liable for deducting a certain amount as penalties. This
can also happen in case of delay in completing the work.
Moreover, extra payments are given if any additional
work is done.

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CONTRACTS WITH ESCALATION CLAUSE
• Contracts like these have a provision that the fixed price
may increase or decrease in certain situations. Moreover,
these are only relevant when both parties mutually agree
on this procedure.
• For example, the total amount increases with a hike in
material cost, wages, or other major costs. Whereas if
there is any reduction, it implies the overall cost.

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COST PLUS CONTRACTS
• Such contracts make it difficult to assert any cost in
advance. In situations like this, no fixed amount is pre-
determined for the contract.
• A client pays all the allowable costs to a contractor. In
addition, the contractor gets a fixed percentage of the
profit or a fee for overall profits.

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LIMITATIONS OF CONTRACT COSTING
1.Complexity of Projects: Contract costing is most suitable for projects that are relatively
large and complex. For small projects, the overhead of maintaining a detailed costing
system might outweigh the benefits.
2.Accuracy Challenges: Estimating and allocating costs accurately can be challenging,
especially in long-term projects where economic conditions, material costs, and labor
rates can fluctuate.
3.Time-Consuming: Maintaining detailed records for each contract can be time-consuming
and may require a dedicated team to manage the paperwork and calculations accurately.
4.Difficulty in Overhead Allocation: Allocating overhead costs to specific contracts can be
complex. Overheads such as administrative expenses, office rent, and utilities are incurred
for the entire organization, making it difficult to distribute them accurately across
individual contracts.
5.Inflexibility: Once a costing method is chosen for a contract, changing it midway can be
difficult and may lead to inconsistencies in financial reporting.

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 ADVANTAGES AND DISADVANTAGES
FOR THE CONTRACTOR

• ADVANTAGES
• Assurance of fixed profit margin.
• Lesser chance of incurring any loss on
the contract.
• Any fluctuations in the market do not
affect the contractor.
DISADVANTAGES
• Discourages a contractor to take any
measure for cost reduction as profit is
based on the cost.
• There are chances of disputes arising
among parties.

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 ADVANTAGES AND DISADVANTAGES
FOR THE CONTRACTEE
• Since the price is on actual
cost this satisfies their
needs.
• A contractee has protection.
• Encourages wastage of
resources, as the higher the
cost more the profit will be.
• The amount a contractee
needs to pay is uncertain as
it depends on the
completion of work.
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Example
Consider a construction company, XYZ Builders, that has been
contracted to build a new office complex for a client, ABC
Corporation. The contract specifies the construction of a 10-story
building with specific architectural features and amenities. The
project is expected to take 18 months to complete.

• Cost breakdown
• Find the total estimated cost of the project
• Profit calculation

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Cost breakdown for XYZ builders
1.Materials: XYZ Builders need to purchase construction materials, including
steel, cement, bricks, and other supplies, specifically for this project. The
cost of materials for this project is estimated to be Rs.2,000,000.
2.Labor: Skilled and unskilled labor will be employed for various tasks such
as excavation, masonry, plumbing, electrical work, etc. The total labor cost
for the entire project is estimated to be RS.1,500,000.
3.Overheads: This includes indirect costs such as administrative expenses,
utilities, office expenses, and supervision costs. Overheads for this project
are estimated to be Rs.300,000.
4.Other Costs: XYZ Builders might incur additional costs related to
equipment rentals, transportation, and site-specific expenses. These costs
are estimated to be Rs.200,000.

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Total Estimated Cost of the Project
• Total Project Cost = Materials Cost + Labor Cost + Overheads + Other
Costs
• Total Project Cost = Rs.20,00,000 + Rs.15,00,000 + Rs.300,000 +
Rs.200,000 = Rs.40,00,000
• In this case, XYZ Builders would use contract costing principles to
keep track of expenses specific to the ABC Corporation project. They
would compare these costs to the contract price agreed upon with
ABC Corporation to ensure that they remain within budget and to
calculate the profitability of the project.

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• XYZ Builders, after completing the construction, finds that the actual
costs incurred during the 18-month project were Rs.42,00,000. The
company had agreed upon a contract price of Rs45,00,000 with ABC
Corporation.
• Profit Calculation:
• Profit = Contract Price - Actual Costs
• Profit = Rs.45,00,000 – Rs.42,00,000 = Rs.300,000
• In this case, XYZ Builders made a profit of Rs.300,000 from the project.
This profit amount is crucial for the company's financial analysis and
helps them evaluate the success of the project. If the actual costs had
exceeded the contract price, the company would have faced a loss on
the project. Contract costing allows companies to closely monitor their
financial performance on individual projects, ensuring profitability and
sustainable growth.
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CONTRACT ACCOUNT
• When a contractor has accepted a contract, a separate account is opened
for each contract, bringing together all the costs relating to a
particular contract.
• A serial number is assigned to each contract, which is known as a
contract account.
• All expenses incurred in fulfilling a contract (e.g., materials, wages,
direct expenses, cost of sub-contracts, cost of special plants, and
indirect expenses) are debited to a contract account.
• Similarly, expenses accrued or outstanding on the contract at the end of
the accounting period are also debited to the contract account.

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• At the end of the accounting period, the following will appear on the credit side of
the account:
• Materials returned to the supplier
• Materials and plant returned to store
• Materials transferred to other contracts, stolen, destroyed, sold, or in hand
• Materials and plant stolen or destroyed are abnormal losses and should be
charged to the profit and loss account.
• Similarly, profit or loss arising from the sale of the plant or materials should also
be transferred to the profit and loss account by way of abnormal items.
• The other items to be shown on the credit side of the contract account are contract
price (in completed contracts) and the work-in-progress, which consists of the
value of certified work and the cost of uncertified work (in incomplete contracts).

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Treatment of Specific Items in a Contract Account

• Materials
• The cost of materials purchased directly or issued from stores will appear on the debit
side of the contract account. Materials returned to suppliers and stores will appear on
the credit side.
• Amounts received from the sale of surplus materials will be credited to the contract
account, while any profit or loss arising from them is to be transferred to the profit and
loss account by way of abnormal items.
• Materials that are lost, stolen, or destroyed by accident (e.g., in a fire) will be charged to
the profit and loss account by way of abnormal loss.
• The values of the material in hand at the end of the accounting period will appear on the
credit side of the contract account.
• Sometimes, materials are transferred from one contract to another contract. If so, then
the contract receiving the materials is debited and the contract sending the materials is
credited.
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Labour cost
• Every worker who is engaged at the site of a particular contract,
irrespective of the nature of the work they perform, is treated as a direct
worker, and they receive their wages as direct wages.
• Such wages are to be charged to the particular contract directly.
• If a worker (generally the supervisory staff) is engaged at two or more
contracts, his total wages may be apportioned to different contracts
based on the time devoted to each one (or on some other equitable
basis).
• Wages accrued or outstanding at the end of the accounting period should
appear on the debit side of the contract account.

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Special Plant

• The plant purchased by a contractor to execute the contract may be divided into two
parts: special plant and general plant.
• Special plants are specifically purchased for a particular contract, and they are expected
to be used for that contract over a long period.
• The value of the special plant at the start of the use period (i.e., the original cost
including installation charges or written down value) is debited to the contract account.
• At the end of the accounting period, the value of the plant after providing an
appropriate amount of depreciation (i.e., depreciated value) should be credited to the
contract account.
• In this way, the depreciation on the plant is automatically charged to the contract
account.
• When calculating the value of plant in hand, the value of plant returned to store, plant
sold, and plant destroyed, among others, should also be considered.

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GENERAL PLANT
• In contrast to a special plant, a general plant is purchased for use at two
or more contracts.
• For a general plant, an hourly, daily, weekly, or monthly rate of
depreciation should be determined, and the amount of depreciation can
be charged to each contract according to the actual use of the plant at the
site of the contract.

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• Direct Expenses
• All expenses that have been incurred specifically for a particular contract
(other than material cost and direct wages) are direct expenses, and they
should be debited to the contract account.
• Examples of direct expenses include hire charges of special plant (not
owned), carriage on materials purchased, and travel expenses relating to the
contract.
• Indirect Expenses
• Some expenses can't be directly charged to a particular contract, including
the salary of the general manager, the salary of an architect engaged at
several contracts simultaneously, the salary of a store-keeper, and store and
office expenses.
• Since these expenses are incurred for the business as a whole, they are to be
apportioned to the different contracts on some equitable basis.
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• Work-In-Progress
• For an incomplete contract, the amount of work-in-progress to
be included on the credit side of the contract account
comprises:
• Work certified
• Work done but not certified

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• (i) Work Certified
• In large contracts, the contractor periodically receives sums of money from the contractee.
These sums are paid against invoices issued by the contractee's architect, surveyor, or engineer
regarding the value of the work completed so far.
• The work completed by the contractor and certified to be complete by the contractee's
architect or engineer is classed as work certified (or work completed and certified).
• (ii) Work Done but Not Certified
• Work relating to an incomplete contract that has been done but has not yet been certified by
the contractee's engineer or architect is known as uncertified work (or work done but not
certified).
• Work done but not certified is the work done since the most recent certification, and it should
be valued based on the actual cost.
• In an incomplete contract, the amount of work-in-progress (i.e., both work certified and work
done but not certified) at the end of the accounting period is debited to the work-in-progress
account and credited to the contract account.
• At the beginning of the next accounting period, this amount is debited to the contract account
and credited to the work-in-progress account.
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QUESTION
• A company's contract ledger shows the following details in respect of
Contract No. 50, which commenced on 1 April 2019.
• The contract was completed by 31 March 2020 at a contract price of
$200,000.
• The values of the materials and plant returned to store on 31 March 2020
were $6,000 and $12,000, respectively. The contract price was received in
full on 31 March 2020.
• Required: Prepare a contract account and contractee's personal
account.

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SOLUTION

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MCQs
• _________ is the person for whom the Contract job is undertaken.
(a) Contractor
(b) Contractee
(c) Sub-contractor
(d) Job-worker
• Which one of the following is not a contract cost ?
(a) Direct wages
(b) Depreciation of plant
(c) Sub-contractors’ fees
(d) Architects’ certificates

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• Contract costing is usually applicable in
(a) Constructional Works
(b) Textile Mills
(c) Cement Industries
(d) Chemical Industries
• In contract costing payment of cash to the contractor is made on the
basis of
(a) Uncertified work
(b) Certified work
(c) Work in progress
(d) Retention Money

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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.

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ANSWERS
• (b)CONTRACTEE
• (d)ARCHITECTS’ CERTIFICATES
• (a)CONSTRUCTIONAL WORKS
• (b)CERTIFIED WORK

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CONCLUSION
• As we conclude our discussion on contract costing, it's important to
recognize that it's not only an accounting practice but a strategic tool for
businesses to effectively manage projects and contracts. The ability to
allocate costs accurately, manage risks, and maintain transparency in
financial dealings is essential for long-term success in a competitive
marketplace. By applying the principles and best practices discussed in
our exploration of contract costing, businesses can enhance their project
management capabilities, ensure financial stability, and build lasting
client relationships.

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THANK YOU