Contract costing is a form of specific order costing used to track all income and expenditure associated with individual long-term contracts. Under this method, each contract is treated as a separate cost unit, and a dedicated contract account is maintained to record all contract-related transactions.
The method is used when work is carried out to a customer's specific requirements and spans multiple accounting periods. It is commonly applied in industries such as construction, civil engineering, shipbuilding, and other project-based sectors where contracts are large-scale and completed over an extended period.
What are the common contract structures?
Every contract involves two parties: the contractor, who executes the work, and the contractee, who commissions and funds it. Contract costing is applied across different contract structures, each carrying a different risk profile for both parties.
Fixed price contract
In a fixed-price contract, the contractor agrees to complete the work for a predetermined sum. All cost overrun risk sits with the contractor. If material or labour costs rise, the contract price does not automatically adjust.
Cost plus contract
In a cost-plus contract, the contractee reimburses all actual costs incurred and pays an agreed fee or percentage on top as profit. The contractor carries no overrun risk, but the contractee has limited visibility over final costs until the project is complete.
Since reimbursement is based on actual costs incurred, the final contract value may remain uncertain until completion, although the contractee generally receives detailed cost reports throughout the project.
What are the key features of contract costing
Several features distinguish contract costing from other costing methods. The most important are as follows:
- Separate accounts for each contract: A unique contract number is assigned to every project, and a dedicated contract account records all costs and revenues for that contract. This helps the contractor assess profitability at the individual contract level.
- Site execution: Work is performed at the site rather than in a factory or workshop.
- Longer duration: Contracts usually span more than one financial year, creating the need for periodic profit recognition and work-in-progress accounting across multiple accounting periods.
- Progress payments: The contractee makes progress payments as work advances, usually based on the value of work certified by an independent surveyor or engineer.
- Escalation clause: If the costs of labour, materials, or other inputs increase beyond a specified limit, the contract price may be revised accordingly. This protects the contractor from absorbing unforeseen cost increases unilaterally.
- Retention money: The contractee usually withholds a portion of each certified payment as a financial safeguard against defective work or incomplete obligations. This amount is released to the contractor only after satisfactory completion and, in some cases, after a defect liability period.
Profit recognition on incomplete contracts
This is where contract costing differs significantly from many other costing methods. Since contracts often run over multiple years, profit cannot simply be deferred until completion. Recognising no profit during execution and all profit at completion would distort financial statements.
For entities following AS 7, the percentage of completion method is generally used, under which revenue and costs are recognised in proportion to the stage of completion.
For entities following Ind AS, revenue recognition is governed by Ind AS 115, which recognises revenue over time when specified performance obligation criteria are satisfied. In practice, this often produces results similar to a percentage of completion approach for many long-term construction contracts.
The stage of completion is generally measured as the cost incurred to date divided by the total estimated contract cost, multiplied by 100.
Depending on this:
- Where the outcome of a contract cannot be reliably estimated, revenue is recognised only to the extent of costs that are probable of recovery.
- Where a loss is expected on a contract, the full anticipated loss must be recognised immediately as an expense, irrespective of the stage of completion.
Example:
A civil engineering firm enters a fixed-price contract to construct a flyover for ₹50 lakh. The estimated total cost is ₹40 lakh. At the end of Year 1, costs incurred are ₹20 lakh.
- Stage of completion = 20 ÷ 40 × 100 = 50%
- Revenue recognised in Year 1 = 50% of ₹50 lakh = ₹25 lakh
- Cost recognised in Year 1 = ₹20 lakh
- Profit recognised in Year 1 = ₹5 lakh
In Year 2, the estimated total cost rises to ₹52 lakh due to a material price increase, thereby exceeding the contract price of ₹50 lakh. A loss of ₹2 lakh must be recognised immediately in that period, even if the contract is not yet complete.
Conclusion
Contract costing is a costing method used by businesses undertaking long-term, project-based work. It helps track contract-specific income and expenditure, monitor project profitability, and support financial reporting throughout the life of a contract.
TallyPrime helps businesses manage project-based cost tracking through job costing features, making it easier to maintain accurate records across contracts and accounting periods.
