What is Contract Costing?

Contract costing is a method of cost accounting specifically tailored for businesses involved in large-scale, long-term contracts. These contracts are usually one-off projects undertaken by contractors and are executed according to the client’s (or contractee’s) specifications. Contract costing is often applied in industries where work is carried out off-site, such as construction, engineering, shipbuilding, and infrastructure development. This method enables companies to track costs and revenues for individual contracts to determine profitability, manage resources efficiently, and control expenses.

In simple terms, contract costing can be defined as a system of recording, classifying, and analysing the costs associated with specific contracts. It helps businesses assess profitability, monitor project progress, and manage financial risks over the contract’s lifecycle.

Contract Costing: Definition and Meaning

According to the Chartered Institute of Management Accountants (CIMA), contract costing refers to “a type of specific order costing that applies when work is performed to the customer’s unique specifications and each order is of extended duration.” The contractor carries out the work based on the contractee’s specific requirements, and the contract often spans several accounting periods, making this method suitable for large, long-term projects.

The meaning of contract costing lies in its ability to help businesses manage complex, long-duration projects by providing a detailed breakdown of costs associated with each contract. The process of contract costing allows contractors to assign costs such as labour, materials, and overheads to each individual contract, enabling them to determine the total project cost, monitor progress, and assess the profitability of the contract.

Contract costing is also known as project costing or construction costing in some industries. These terms are used interchangeably, particularly in industries such as construction, shipbuilding, and civil engineering.

Features of Contract Costing

The features of contract costing include several unique elements that distinguish it from other costing methods:

1. Cost Unit: Each contract is treated as a separate unit of cost. The costs related to materials, labour, overheads, and subcontracting are all traced to the contract.
2. Long-Duration Projects: Contracts are typically long-term, spanning multiple accounting periods, sometimes lasting several years.
3. Site-Specific Costs: Most contracts are performed on the contractee’s site, meaning costs like transportation, site equipment, and labour are directly tied to that specific location.
4. Direct and Indirect Costs: Contract costing includes direct costs such as materials and labour and indirect costs like administrative overhead, which are allocated to contracts based on predetermined criteria.
5. Payment in Installments: Contractors are usually paid in instalments as the work progresses, with each payment corresponding to specific milestones.
6. Profit Calculation: Profits are calculated progressively, allowing the contractor to report partial profits annually instead of waiting until the contract’s completion.

Contract Costing in Cost Accounting

In cost accounting, contract costing plays a crucial role in helping businesses monitor and control costs for large-scale projects. It is typically used by contractors in industries such as construction, shipbuilding, and public infrastructure projects. The method helps allocate costs to specific contracts, ensuring accurate cost management, resource allocation, and profit calculation.

In cost accounting, contract costing allows businesses to:

• Track expenses related to individual contracts.
• Determine profitability at various stages of contract completion.
• Allocate resources efficiently to avoid cost overruns.
• Monitor progress and budget adherence over the course of the project.

Basic Method of Contract Costing

Contract costing is a basic method of cost accounting, specifically designed for tracking costs related to large, custom projects. It is most suitable for contractors working in industries that require long-term, site-specific work. The system ensures that costs are accurately allocated to the relevant contract, allowing contractors to manage their finances effectively.

Application of Contract Costing 

Contract costing is applicable in industries where projects are unique, non-repetitive, and extend over a long period. These industries include:

• Construction: Building roads, bridges, dams, and buildings.
• Shipbuilding: Constructing ships or vessels.
• Engineering: Working on infrastructure or mechanical projects.
• Public Works: Building infrastructure such as railways, drainage systems, and canals.

In these industries, contract costing helps allocate costs and manage profitability over the lifecycle of each project.

Contract Costing Examples

To understand contract costing examples, let’s consider the following scenario:

Example 1: A construction company, ABC Builders, is awarded a contract to build a bridge for $10 million. The company estimates the project will take two years to complete. Direct costs include labour, materials, equipment rental, and overheads. Payments are made in instalments as the project reaches milestones. ABC Builders uses contract costing to track each expense related to the project, including the subcontract cost paid for the contract, which is debited to the specific contract account.

Example 2: A shipbuilding company is contracted to build a cargo vessel over a period of 18 months. The company tracks labour costs, material costs, and overheads directly tied to this contract. As the project progresses, partial profits are recognised based on completion percentages.

Subcontract Cost Paid for the Contract

In contract costing, the subcontract cost paid for the contract is debited to the specific contract account. This is because the cost of subcontractors is considered a direct cost of the contract. When subcontractors are hired to complete part of the project, their costs are recorded under the relevant contract, ensuring all expenses are accurately tracked.

Advantages and Disadvantages of Contract Costing

Advantages:

• Detailed Cost Analysis: Helps track specific costs related to individual contracts.
• Profit Recognition: Allows for partial profit recognition based on project completion.
• Resource Efficiency: Ensures resources are used effectively and waste is minimised.

Disadvantages:

• Time-Consuming: Tracking costs for long-term contracts requires ongoing effort.
• Complexity: Managing multiple contracts simultaneously can complicate cost tracking.
• Uncertainty: Unforeseen changes in material prices or labour costs can affect the overall profitability of the contract.

Conclusion

Contract costing is an essential method of cost accounting for industries involved in large, long-term projects. It enables contractors to allocate costs accurately, manage resources, and calculate profits progressively as the contract reaches completion stages. By applying contract costing, businesses can monitor their finances closely, ensuring that projects stay on budget and are completed efficiently. The structured nature of contract costing offers transparency, flexibility, and control, making it invaluable for contractors and clients alike.