Contract costing definition
/What is Contract Costing?
Contract costing is the tracking of costs associated with a specific contract with a customer. For example, a company bids for a large construction project with a prospective customer, and the two parties agree in a contract for a certain type of reimbursement to the company. This reimbursement is based, at least in part, on the costs incurred by the company in order to fulfill the terms of the contract. The company must then track the costs associated with that contract so that it can justify its billings to the customer. The most typical types of cost reimbursement are noted below.
Fixed Price Contract
Under a fixed price contract, the company is paid a fixed total amount for completing the project, possibly including progress payments. Under this arrangement, the company will want to engage in contract costing to compile all of the costs relevant to the construction project, just to see if the company earned a profit on the deal. Under these arrangement, companies tend to define the deliverable tightly, so that they can charge additional fees for any add-on work requested by the customer.
Cost Plus Contract
Under a cost plus contract, the company is reimbursed for the costs it incurred, plus a percentage profit or fixed profit. Under this arrangement, the company will be forced under the terms of the contract to track the costs related to the project, so that it can apply to the customer for reimbursement. Depending on the size of the project, the customer may send an auditor to examine the company's contract costs, and may disallow some of them. Auditors can be quite picky about whether a cost should be assigned to a contract, since the company can use the contract as a dumping ground for costs that can now be reimbursed by the customer.
Time and Materials Contract
A time and materials contract is similar to the cost plus arrangement, except that the company builds a profit into its billings, rather than being awarded a specific profit. Again, the company must track all contract costs carefully, since the customer may review them in some detail. In particular, customer auditors may question why someone charged time to a job, and whether the hourly rates charged are appropriate.
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Overhead Allocations to Contracts
Contract costing can involve a considerable amount of overhead allocation work. Customer contracts typically specify exactly which overhead costs can be allocated to their projects, and this calculation may vary by contract. This can constitute a large part of the work associated with contract costing, and will also likely attract considerable attention from customer auditors who are reviewing accumulated contract costs. This is also a major area for negotiated price changes, since the amount of overhead allocated to a contract can be subject to some interpretation.
Organization of Contract Costing
In some industries, such as government contracting and commercial construction, contract costing is the primary task of the accounting department, or may even be organized as an entirely separate department. Proper contract costing can contribute a considerable amount of profits, and so is typically staffed with more experienced contract managers and accountants. A common best practice is to provide extensive training to those accountants assigned to a contract, with oversight by a more experienced accountant. Doing so minimizes the number of contract accounting errors, as well as disputes with customers.