Definition
Contract costing, also known as project or terminal costing, is a form of specific order costing used in industries where each contract or job is significantly large, unique, or distinct. It involves tracking all direct and indirect costs related to a particular contract, from initial bidding to completion. The goal of contract costing is to determine the total cost and profitability of each contract to aid in decision-making and financial management.
Key Takeaways
- Contract Costing is primarily used in industries that work on significant, individual projects, such as construction, shipbuilding, and engineering. It helps in estimating the cost, managing finances, and ensuring profitability for each individual contract.
- The process of Contract Costing involves detailed cost recording, careful monitoring, and thorough comparison of actual and estimated costs. It allows for financial control at different stages of a contract, providing companies with the ability to manage resources effectively and avoid overspending.
- One unique feature of Contract Costing is the concept of ‘Work-In-Progress’. Given that many contracts span over several accounting periods, it’s crucial to identify the value of unfinished work at the end of each period for accurate profit reporting. This is achieved through methods such as the cost-to-cost method, efforts expended method, etc.
Importance
Contract costing is a critical concept in finance as it facilitates the calculation of the exact cost pertaining to a specific contract.
This method of costing is especially important in industries such as construction, shipbuilding, or any project-based business where large and unique contracts are signed extending over long periods.
Contract costing helps in economic and accurate cost computation, which aids in determining the viability and profitability of individual contracts.
Moreover, it offers guidance on future bids, enhances budgeting and pricing decisions, assists in the control of costs, and provides insights into each contract’s financial performance.
Hence, contract costing is essential in decision-making processes, profitability analysis, and financial management of businesses operating in project-based sectors.
Explanation
Contract costing is fundamentally employed in the financial management of significant projects that often take a considerable amount of time to complete. These could include construction, civil engineering works, or manufacturing of speciality equipment.
The essence of contract costing is to ensure that every cost related to a particular contract is meticulously documented and controlled. This allows the business to successfully track, understand, and manage the profitability of each contract.
Overall, contract costing serves a critical purpose of providing financial transparency and control over long-term projects. It allows the involved parties to accurately price their contracts and ensure they’re making a profitable deal.
Moreover, this can be used to pinpoint where money is being spent and where costs may be reducing the profitability of a job. Additionally, it can act as an important tool for planning and decision-making, enabling businesses to evaluate the financial viability of future projects based on the detailed cost history of past contracts.
Examples of Contract Costing
Contract costing typically refers to the management of various costs associated with a particular contract. It’s often used in industries where large-scale projects are common. Here are three real-world examples:
Construction Industry: This is perhaps the most common example of contract costing. A property developer might enter a contract to build a new residential building. The costs associated with this contract could include the price of raw materials like cement and steel, labor costs, equipment rental, permits and licenses, and even the cost of any subcontractors hired for specialist work like plumbing or electrical. All of these costs would be tracked to ensure the project remains within budget.
Manufacturing Industry: In manufacturing, a company might take on a contract to produce a certain number of items for another firm (Original Equipment Manufacturer, OEM contracts). The contract costs will include the raw material cost, labor cost, the depreciation of machinery used for production, utility costs like electricity, and any other overhead costs.
IT Services: IT companies often sign contracts to develop software systems for clients. The contract costs could include the salaries of the software engineers and coders working on the project, the cost of hardware or software required to develop and test the new system, and other overheads like office rent and electricity. Again, it’s crucial to track these costs accurately to ensure that the contract remains profitable.
FAQs on Contract Costing
What is Contract Costing?
Contract Costing is a specific form of costing used in situations where individual contracts or jobs are undertaken, each of which is treated as a separate cost unit. It is a form of specific order costing that applies where work is undertaken according to customers’ specific requirements.
What is the purpose of Contract Costing?
The purpose of Contract Costing is to gather and monitor the costs associated with a specific contract. It helps in comparing these costs with the original estimated costs to determine the financial effectiveness and forecasting accuracy.
What elements are included in Contract Costing?
The elements included in Contract Costing are direct materials, direct labor, and other direct expenses along with a share of overheads. All these costs combined make the total contract cost that is compared to contract revenue to find the profitability of the contract.
How is Contract Costing different from Job Costing?
While both Job Costing and Contract Costing are specific order costing methods, they apply to different situations. Job Costing is typically used when the work is short term and demands low capital expenditure. On the other hand, Contract Costing is used for longer-term contracts that require significant capital outlays.
What is a Notional Cost in Contract Costing?
Notional Cost, or imputed cost, in Contract Costing refers to the cost that does not involve any cash outflow but is relevant to the decision-making process. For example, an opportunity cost of deciding between two competing projects can be considered a Notional Cost.
Related Entrepreneurship Terms
- Project Contract: A legally binding agreement outlining the project goals, costs, and deliverables.
- Job Costing: The process of accumulating information about costs associated with a specific project or contract.
- Cost Variance: The difference between the actual costs of the contract project and the budgeted or forecasted costs.
- Overhead Costs: Indirect costs or ongoing business expenses not directly attributable to the production of a specific product or service, but associated with operating expenses of the contract.
- Cost Estimate: A calculation of the anticipated costs of the contracted project based on the contract specifications and requirements.
Sources for More Information
- Accounting Tools: Offers comprehensive information about contract costing from a finance perspective.
- Investopedia: This is a trusted platform loaded with abundant resources on finance and investing, including topics about contract costing.
- Accounting Coach: Provides free and quality online resources making accounting and finance easier to understand.
- Coursera: Provides online courses on numerous subjects, including accountancy and contract costing. They have a wide range of finance courses from respected universities.
