Terminal or contract costing accounts are favourable for tracking costs incurred in a specific contract with a specific customer. An agreement is based on common terms reached by a contractor and a contractee for a specific job. This agreement must be transparent about the contract cost, the timeline for completion, cost associated, standard of the work, inspection, and several other conditions. The individual executing the agreement is called a contractor. The individual for whom this is implemented is called the contractee. It is an aspect of business costing with jobs that require a long period to finish and comprise multiple activities. A distinct account is unrolled for each agreement in the contract or common ledger. This account gets debited with immediate and indirect expenses and gets credited with the agreed price on fulfilment. The account balance is carried to the Profit and Loss Statement.
Nevertheless, if the assigned job is not completed in the agreed timeline, the contractor may charge penalties as per the agreement or contract.
Did you know? The contract costing method is most commonly used by builders, civil engineers, shipbuilders, and mechanical engineers. The contract is generally performed at the customer's site and according to his specifications.
Contract Costing: Elements
- The Material Specifically Purchased for the Contract:
For materials specially purchased for a particular contract, a business has to debit the contract account by the value of materials, and the cash account of the material supplier is to be credited.
- Common Material Brought from Stores:
The non-specific material utilised by all contractors from the same source is brought in from the common stores. The specific contract account is debited while a store account shall be credited by the price value of the material.
The leftover material by the end of a contract is returned back to the stores. Thus, the contract account gets credited while the store contract account is debited.
- Sale of Excess Raw Material:
Whether a contractor makes a profit or loss from the sale of extra material, both are shown in the contract’s Profit and Loss account. The earnings from the sale, if any, get credited to the contract account.
- Material Transfer from One Contract to Another
Transferring raw material, plant, and equipment from one contract to another in the event of a need, emergency, or the completion of either contract is a common practice. If any material is transferred, it is tagged with a "Material transfer note." It will be debited in the receiving contract account and credited in the sending contract account.
- Material Transferred by the Contractee to the Contractor
There is no need to charge the cost of the material to the contract account if the contractee agrees to furnish materials for the contract. To ensure that any leftover materials can be returned to the contractee at the end of the project, the contractor will keep a separate record.
- Direct Labour
Every employee on a contract site is often handled as direct labour, with the associated cost typically charged to the debit side of the contract account. Direct labour, therefore, refers to workers and supervisors specifically assigned to completing a single contract. Other employees, such as a guard, a supervisor, a junior engineer, etc., may also be included.
- Indirect Labour
Indirect labour refers to workers who perform their services on an hourly or daily basis under many contracts at the same time. Supervisors, such as junior engineers and managers with several contracts, may be included. Such contractors will each receive a fair share of the indirect labour costs.
For each contract a company undertakes, a separate wage sheet must be kept to track the wages spent on that particular contract.
Machinery and Plant
When the plant or machinery is purchased for one or multiple contracts, then the depreciation is charged for the period for which the equipment is used. This cost will be set off from the contract account.
If the machinery or equipment is used for a shorter period, the percentage of the charge is barely taken with the initial time of possession.
Any sale earnings in the middle of the agreement or upon completion are placed in the agreement account. The profit or loss on a sale like this is carried to the Profit and Loss report.
“Overhead costs” is another term for Indirect Expenses. Common office expenditures and the hiring of common supervisors, while the company is operating a lot of contracts, are examples of indirect costs. The costs will be reasonably divided across the contracts.
In cost-plus contracts, the contractee agrees to pay an additional sum, expressed as a percentage of overhead cost and profit. A cost-plus contract system is used when a contractor finds it hard to estimate the cost of a project due to a lack of past records.
The cost-plus contract approach is the ideal choice if the contractor is unable to estimate the costs to be paid or the accurate amount of work to be done. When the contract is finished, it guarantees the contractor a reasonable profit. Usually, the government and the contractor enter into these kinds of contracts.
At the time of entering into the contract, it's likely that specific tasks might not have been discussed or remembered. As a result, at the end of the contract or at any time, the contractee may change the terms or request additional work.
For this extra work, the contractor will charge you.
The main contractor may occasionally outsource his specialised work to a different contractor they trust. It's known as subcontracting. Steelwork, electricity, flooring, decoration, and other tasks may be subcontracted. The cost of the subcontract will be charged to the main contract's debit side as a direct cost to the main contract.
The contract agreement's escalation clause protects the interests of both the contractor and the contractee. The escalation clause states that the contract price will be increased as necessary if the cost of labour and raw materials (which is beyond the contractor's control) increases by more than a certain percentage over the going rate at the time the agreement was signed. The escalation clause will describe how the price will be adjusted.
The contractor will pay as per the work approved by the surveyor. It is standard procedure for the contractee to pay the contractor a set percentage of the specific work. For instance, if the contractee pays 70% of the approved work's value, which is for instance ₹1,00,000, the total payment due is ₹ 70,000. (70 % of work approved). Retention money is the remaining ₹30,000 that has not been paid.
The cash ratio is the portion of the approved work paid for by the contracting party to the contractor.
Retention money is the sum that, in the example above, is not paid off (30%) for work certified. The retention funds serve as a guarantee for any subpar or flawed work completed by the contractee.
Features of Contract Costing
The fundamental features of contract costing are outlined below.
- The job is done at the contractee's work site, which is separate from the contractor's premises.
- Contracts are major tasks that may take longer to complete, often with multiple accounting periods.
- A separate account is created for each contract to calculate the profit or loss on each transaction.
- The agreements are fulfilled per the specifics given by the one giving the contract.
- The majority of the materials are bought, especially for each contract.
- The payment by the one providing the contract is given to the contractors in instalments or based on the scale of the job completed.
- Contract costing is suitable for ship-building, engineering work, road construction, and building construction.
Differences between Contract Costing and Job Costing
- Contracts are large-scale, and jobs are small-scale (lasting for less than a year).
- While a job is often completed inside the factory, contract work is completed on the job site (outside the factory).
- While contracts for projects like Bhakhra Dam, Tihri Dam, SYL Canal, thermal power plants, etc., need a sufficient amount of time to complete (more than a year), jobs typically take less time to complete (usually less than a year).
- In comparison to job costing, contract costing involves significant investment and expenditure.
- While both direct and indirect costs are equally significant for jobs, big expenses in contract costing are directly tied to that contract.
Also Read: What is Double Entry System of Accounting
What Is Contract Costing and Its Objectives?
The fundamental objectives of contract costing include:
- Finding out the total contract cost
- Find out the profit or loss from the contracts
- Contract costing rules to be followed
- Contract account to be maintained
Contractors maintain a contract account. In this, a separate account is opened for each contract they start.
Contract Costing Examples
An example of agreement costing is Konkan Railway and Delhi Metro. Here, two groups have a contract between them. Contractees are the owners for whom the work is completed and contractors are the ones who undertake the work. Here, the cost unit refers to the contract itself.
Another illustration is the building of a bridge on a river at any location. When the bridge is entirely built, the contract account will be closed.