Contract costing: definition; characteristics; applicability, steps of contract costing; types; accounting treatment of contract job; advantages & disadvantages

1.1 Introduction

This kind of costing method is unique in its approach. The definition and the details thereof are discussed hereunder;

Definition: Contract costing method is a job costing methodology under cost ascertainment topic which involves cost data collection for a contract. The contract is categorized as a unit of cost such that the estimation of the total contract cost will be in terms of total cost per contract once it is complete.

NB: Contract costing method is also referred to as terminal costing for this kind of assignment is closed down once it is complete (i.e., books of accounts are closed down).

1.2 Specific objectives of contract costing method

The key note aim of using contract costing method is;

1). For control purposes. The contract costing method is a tool for comparing the actual and estimated contract value so as to decide on how to manage variances thereof.

2). To lay a foundation for cost-plus pricing. The contract job carries detailed cost element to lay the basis for mark-up.

3). Recouping of yearly profits. Even when the job is incomplete, the contractor reaps some profits to the extent to which the contractual project is complete.

4). Utilization of resources. A contractual object guides the management on how to optimally utilize the wealth of the organization for the total cost associated to the project is well estimated.

Characteristics of contract jobs

2.1 Introduction

The task of contract costing method applies on contract jobs or assignments. These contractual assignments are dominated by the following features.

1). Long term assignment

A contract job is a task that takes reasonably longer period of time to completion. It can be an assignment of one or more than one year. In other words, it can overflow from one financial year to another.

2). On site task

A contractual job is undertaken from the contractee’s location or site. That is the start or initiation of the project is at the site chosen by the client but not the contractor’s opinion.

3). Contract job is exposed to high risk and uncertainty.

The contract is at high risk or danger. This is because such projects are bound to failure or be affected by many external factors such as technological change and or political change which can make the task come to a standstill.

4). A contract is a cost unit

A contract is the assignment which entails the whole job carries only one cost value that has accumulated such as $12,000 per contract.

5). Each contract is against a stand-alone ledger account.

A contract has a specific account where the recording of the costs is deposited. That is, each contract is kept in a separate ledger account.

6). Apportionment of profitability over time.

As the contractual period advances, the accountant assigns some levels of profitability for each year which is complex.

7). Contract jobs are tied to direct costs

Contract tasks have inputs which are purchased specifically to complete that task. Such as specific raw materials, labor cost and overheads.

8). Overhead cost is apportioned or allocated to contract job in an easy way.

Overhead costs are the indirect costs associated with the production or completion of a certain task. This is because most of the expenses and direct and very few elements fall under overhead cost category.

9). Contract jobs are associated with specialist sub-contracting.

Some specific activities to be undertaken to complete the contract require specialists. Hence experts are engaged in the contract.

10). Contract jobs are characterized by acquisition of plants properties and equipment (PPE) dedicated for that particular project.

For every contract assignment, specific fixed/non-current assets are acquired to carry out the specific activities thereof.

11). The contract client pays for the contract price in phases based on the level of contract completion level.

That is, the whole price of the contract assignment is not paid at once. It a step-by-step process.

12). There exists a completion penalty provision or clause

The contractual agreement is inclusive of the legal action to be undertaken in case either of the parties breach the terms and conditions of the contract.

13). Escalation clause inclusivity.

Contract job undertaking by the contractor goes together with the provision of compensating the contractor over cost inflation such that if cost of the contract increases, the price of the contract is adjusted upwards.

14). Retention money provision.

A contract job being done costing carry a provision that there must be a certain percentage put aside to take care of incomplete project issues in case they arise.

Applicability of contract costing methods

3.1 Introduction

Contract costing is suitable in assignments which has to do with;

  1. Construction of projects such as roads, bridges and dams
  2. Real estate development such as construction of residential houses
  3. Construction of bridge building
  4. Engineering works such as construction of milk processing plant.

Steps of costing a contract job

4.1 Introduction

The following are the systematic steps that guide a contractor in contract costing

Step-1: Contract account preparation

For every contract assignment, a ledger account is opened to record all transaction related to that assignment.

Step-2: Direct and indirect cost allocation/apportionment to the contract job.

The direct costs associated to the contract are recorded on the debit side of the ledger account. Similarly, indirect cost is also added to the ledger account.

Step-3: Material or plant transfer

In this step, the contract ledger account is credited with materials, plants and other used up materials.

Step 4: Contract pricing process

The value of the contract is determined at this point where by on top of the cost incurred, an additional margin is added on the credit (CR) side of the contract account.

Step 5: Establishment of contract profitability level

Compute the monetary value of the DR and the CR and then determine the difference between the two sides. The results will imply either profit or loss of the contract assignment.

Types of contract jobs

5.1 Introduction

There are two main types of contracts. Or in other words, a contract job may assume two types of aspects

i). Fixed price contract

ii). Cost plus contract

Accounting treatment of contract job

6.1 Introduction

Contract job has its unique technicalities for it to be operational. Some of the key aspects or components that you need to understand and know how to undertake the accounting treatment are as follows;

6.1.1 Direct Materials

Contracts are characterized by materials which are directly assigned for a particular job. 

6.1.2 Direct Labor

All laborers working directly or full time in a particular contract are referred to as direct labor.  

6.1.3 Indirect Labor

This is labor which does not serve a particular contract.

6.1.4 Plant and Machinery

This is capital cost incurred or paid by the contractor to facilitate the completion of the contract.

6.1.5 Partially utilized Plant and Equipment

Some plants and equipment are used partially in several contracts. Now, in such a case, it is not possible to permanently assign the asset on a particular project.

6.1.6 Overhead Cost

This is the indirect cost which cannot be straight away be associated with the project.

6.1.7 Escalation Clause

It is a provision that the two parties in a contract agree upon.

6.1.8 Sub-Contracts

This is a part or section of the main contract that require a specialist or expert.

6.1.9 Cost Plus Contracts

With this kind of contracts, the contractor is not in a position to reasonably estimate the final price of the contract or job.

6.1.10 Extra Work to be Done

This is the extra assignment that the client may add to the main contract as time goes by which was not part of the price agreed upon earlier on.

6.1. 11 Certified and Uncertified work

This is the two monetary value aspects of the whole contract determined by an expert, namely the engineer who can be the architect. 

6.1.12 Payment of Certified Work

Payment of certified work by the contractee/client is on the basis of a fixed percentage of the monetary value of the certified work.

6.1.13 Retention Money

Retention money is that part of certified monetary value that is not paid to the contractor for the sake of security to ensure that the contractor finished the assignment in time.

6.1.14 Accounting treatment of both Certified and Uncertified Work in Progress

In contract account, both certified work in progress and the uncertified work in progress is treated as total work forming the whole contract. This is the reason why both aspects are credited in the contract account.

 6.15. Conditions for determining Profit on Uncompleted Contracts 

There are several conditions that the contractor need to comply with before he or she determines or computes the net profit associated with the certified and the uncertified work in progress.

Advantages and disadvantages of contract costing method

7.1 Introduction

The following are the advantages and disadvantages of contract costing method which is under the umbrella of job costing method.

7.1.1 Advantages of Contract Costing Method

  1. Economic resource consumption rate such as direct raw materials, labor and direct expenses is managed by the contractor so optimization of usage is sure.
  2. Easy achievement of contract objective(s) for each contract has its own corresponding ledger account. Hence no mixing of issues.
  3. There is full control of cases of defects arising out of quality deficiency in the contract.
  4. The system or practice of keeping retention money until the contract completion take place helps in improving contract performance efficiency with the contractor.
  5. The approach of a contract in accomplishing a task builds a strong team work amongst the participants which help in fast completion of the projects.

7.1.2 Disadvantages of Contract Costing Method

  1. Time consuming. Most contracts take a while to end and this delays other matters the organization may aim at accomplishing before year end.
  2. Conflict of interest between the two parties on the interpretation of escalation clause. That is, whichever way, one of the parties will have to raise a complaint or be discontented for the clause has to favor either the contractee or the contractor and not both.
  3. Most contractors don’t keep books of accounts so this may lead to improper calculation of profits. This may result to a situation where by the contractor may be making loses without his or her awareness and of course with time the business will collapse for numbers don’t lie.
  4. The engagement is punitive for the contractor has to always keep his eye on the market conditions to avoid suffering losses. Since a contractual assignment may take longer period, the longer the period the more the risk the deal is subjected to. For example, price risk where by the cost of inputs may increase. Hence eating the profits thereof.
  5. Complexity in handling the contracts especially when technical works are to be under taken. This implies that not all entrepreneurs can undertake this venture

About the Author - Dr Geoffrey Mbuva(PhD-Finance) is a lecturer of Finance and Accountancy at Kenyatta University, Kenya. He is an enthusiast of teaching and making accounting & research tutorials for his readers.