Financial Accounting

Introduction to Contract Costing – Explanation

What is a Contract?

The term ‘contract’ refers to the agreement between two parties to do a particular task within a given time frame.

Typically, a contract involves a substantial amount of money and is performed on-site. A contract involves two parties, namely the contractor and the contractee. The individual or entity implementing the terms and conditions of the contract is known as the “contractor.”

Similarly, the individual or entity for whom the labour or task is performed is known as the contractee. The contract and the contractee agree to complete the work in exchange for a sum of money known as the contract price. A contract is typically associated with the construction of buildings, dams, bridges, roads, and plants, among other things.

Types of Contracts

Fixed price contract

The contract that is executed with a definite price agreed upon by both parties is referred to as a fixed price contract. Under the terms of this agreement, the agreed-upon contract price remains unchanged regardless of changes in the material and labour costs associated with the feature. In such a contract, the contractor profits from a decline in the cost of materials and labour. In contrast, the contracting party benefits if the cost of materials and labour rises.

A fixed price contract with escalation and de-escalation clauses

escalation clause is an agreement that aims to reduce the risks that are caused due to the changes in the price of materials, labour and other services. Under this, the contract price is adjusted by the changes in the price of materials, labour and other services.

The contracting party is responsible for the price rise-related cost increase. Likewise, the contract price is reduced if the cost falls below a specified percentage. The term for this is de-escalation or reversal clause. The escalation clause protects both the contractor and the contractor against unfavourable future price fluctuations. A similar clause may also apply when material and labour utilisation surpasses a predetermined threshold. In this instance, however, the contractor must demonstrate that excessive use is not due to a decline in productivity. The contractor allows a discount on the bills he submits equal to the price reduction.

Cost plus contract

A cost-plus contract is one in which the contract price is calculated by adding a certain percentage of profit to the cost. The cost plus contract is used to address the difficulty in determining the contract price caused by the nature of the contract, the duration of its completion, the unpredictability of the materials, the fluctuation of the price level, the introduction of new technologies, etc.

This sort of contract is mostly used by the government for the creation of non-typically manufactured items, urgent repairs to cars, roads, and bridges, etc. Under this sort of contract, the contract begins work and payment is given gradually based on the cost incurred in completed work plus a certain profit percentage.

What is Contract Costing

Contract costing is the process of estimating what the cost of a contract will be to the company. It is a process that allows the company’s management to prepare a budget and forecast their spending throughout the contract. Contract costing is a useful tool that can help you budget, plan and manage costs, and help you negotiate a contract with the subcontractors or suppliers.

Contract costing, also known as terminal costing, is a costing technique similar to job costing and is used by businesses such as builders and public works contractors that perform work on a contract basis.

Characteristics of contract costing

The following are the unique characteristics of contract costing:

  1. Over the course of a year, the contractor begins work on a huge number of major projects.
  2. Contracts are executed at a location other than the contractor’s.
  3. Contracts may be extended beyond a single accounting period.
  4. Materials are acquired and delivered directly to the contract site from the central MITS or are supplied from the central MITS.
  5. Payroll is prepared on-site or centrally at an administrative office.
  6. Subcontractors, such as ventilation engineers, elevator makers, and flooring specialists, may be hired.
  7. Plant and equipment may be acquired or rented from another firm or a central plant department for the term of the contract.
  8. Payment by the customer for various stages of the contract is made only upon receipt of the completed stage’s architect’s certificate. The client withholds a portion of the payment referred to as retention money until a specified amount of time specified in the original contract has elapsed.
  9. Typically, the contract price is determined in advance of the task. Additional work that is determined to be necessary may be billed on a cost-plus basis. Additionally, terms may be Unsorted to let the contractor to pass on to the client any higher expenses incurred as a consequence of increased material, labour, or other expenditures.

READ MORE:  What are capital structure ratios in accounting?
Show More

Leave a Reply

Back to top button