Contract Costing of Construction Industry

Introduction to Contract Costing in the Construction Industry

The costing method commonly practiced by the construction industry is contract costing. Contract costing is a technique used to track the cost of a specific contract with a specific customer. When two parties enter into a contract, for example, a construction company enters into a contract with their client, they must agree on some terms of the contract, and one of the most important terms is the type of reimbursement to the construction company. There are a few types of reimbursement, and they are normally based on the cost incurred by the construction company. The construction company must be able to track the cost related to the contract so that they can justify their billings to the client (Contract Costing: Accounting Tools, 2011).

Types of Contract Costing

There are several common types of contract costing with different reimbursement methods: fixed price/lump sum contract, cost-plus contract, time and material contract, and unit pricing contract (Rodriguez, 2017). Under a fixed price/lump sum contract, both parties must agree on a lump sum price before all the works begin, and the contractor will need to submit a total price for their project. This costing method estimates material cost, labor cost, plus a calculated amount of money expected to cover all of the contractor’s overhead and profit margin. However, this contract is not secured for the contractor as the price is fixed, and they could incur more costs than the price they agreed upon. In a fixed price contract, the client transfers all the risk to the contractor, as they are responsible for proper job execution using their own means under this contract. However, the contractor can ask for a higher return as they bear all the risks. This costing method is recommended for projects with favorable and stable conditions (Rodriguez, 2017).

For a cost-plus contract, the client pays the contractor all the related expenses agreed upon in the contract plus an amount of profit for the contractor. Unlike fixed price contracts, this contract benefits the contractor as they are more likely to recover all their expenses and risks. They are not required to submit an estimate of the full cost before starting the job, and they can receive continuous reimbursement from the client. Some clients will set a limit to prevent the contractor from overspending on construction costs. This contract is suitable for situations with uncertainties (Rodriguez, 2017).

Under a time and material contract, the contractor is paid based on the cost of direct labor and direct materials used, plus an amount that covers the contractor’s overhead and profit (Time and Materials (T&M) Contract: Business Dictionary, n.d.). For time and material contracts, the pay rate for all labor and personnel is specified, typically adding a markup ranging from 15 to 35 percent on the materials used. This contract is the most secure for the contractor, with the customer bearing almost all of the risk. It is only recommended for projects that cannot perform an accurate estimate and where the project scope cannot be defined. To protect the customer, they will set a maximum amount the contractor can charge and maximum labor hours they can use to optimize the contractor’s efficiency (Rodriguez, 2017).

Under a unit price contract, past history and current condition of the asset being maintained are used to estimate the work when establishing this contract. With this estimation figure, the contractors are provided with a more accurate estimation of work and the basis of how they are going to be paid. However, this estimated figure is not the full price for the contract, and the full price of the contract is the amount incurred after all work has been done. Unit price contracts use estimated quantities of items and unit prices of items, such as hourly rate or rate per unit work volume, as the basis for estimating the cost of a project. This contract is recommended when quantities cannot be estimated accurately before the construction project starts. It is also suitable for recurring business (Unit Price Contracts: Government of the Northwest Territories, 2009).

Job Costing in the Service Industry

Job costing is a technique of accumulating all information about the cost, such as the cost of materials, labor, and overhead, for a specific job. This information is useful for a service firm as it will be presented to the customer under the contract, ensuring the customer is aware of how much this job will incur. Additionally, the precision of the company’s estimating system can also be ascertained, as this system plays an important role in quoting a reasonable price for the customer. There are three main types of information that a job costing method should include: direct materials, direct labor, and overhead (The job costing system: Accounting Tools, 2015).

Some service companies track direct materials for each job, while others do not. For instance, accountants or lawyers use binders and paper when providing their service. However, these costs are not included in direct materials as the value of these materials is too insignificant. These materials are known as supplies and are often treated as overhead instead of direct material cost. For some service companies, the costs of materials are more considerable, and they will track the cost of direct materials for each job. For these service companies, these materials are significant in conducting the business. For instance, a car mechanic, who needs spare parts of vehicles to perform repair services, will track the cost of these direct materials for each job performed (Job Costing in Service Organizations: Saylordotorg, n.d.).

For some service companies, direct labor cost might cover the majority of the job cost. To assign direct labor to a job, there are a few methods used by the service company, which include using a timecard, timesheet, or networked time clock application. Through this, they can trace the labor cost incurred as all the working hours of the staff are recorded for each job (The job costing system: Accounting Tools, 2015).

Overhead is assigned to one or more cost pools and charged to each job at the end of the accounting period. These overhead costs are assigned to each job based on a certain cost driver. The cost driver for overhead in the service industry is often the direct labor hour or direct labor cost. Hence, most overhead is assigned to each job based on the direct labor hours used or direct labor cost incurred for the specific job (The job costing system: Accounting Tools, 2015).

The job costing system needs to be customized for some customers to meet their requirements, as some customers will set limits for costs to be charged on the job. Eventually, the job costing system is not generally appropriate for all jobs, as they might comprise a lot of specialized rules. The company must close down the job in the job costing system when the job is completed, or the employee might continue to charge time to the job, adding cost subsequently.

Conclusion

Supposing that the job is in process, the compiled cost of the job should be treated as an inventory asset. This inventory asset will then transfer to the cost of goods sold account when the job is billed to the customer or is written off (The job costing system: Accounting Tools, 2015).

References

• Contract Costing: Accounting Tools. (2011). Retrieved from https://www.accountingtools.com/articles/what-is-contract-costing.html
• Rodriguez, J. (2017). 4 Common Types of Construction Contracts: The Balance. Retrieved from https://www.thebalance.com/types-of-construction-contracts-844483
• Rodriguez, J. (2017). Learn About Lump Sum Construction Contracts: The Balance. Retrieved from https://www.thebalance.com/lump-sum-construction-contracts-844490
• Rodriguez, J. (2017). Construction Contracting: All About Cost-Plus Contract: The Balance. Retrieved from https://www.thebalance.com/cost-plus-construction-contracts-844491
• Time and Materials (T&M) Contract: Business Dictionary. (n.d.). Retrieved from http://www.businessdictionary.com/definition/time-and-materials-contract.html
• Rodriguez, J. (2017). Time and Materials Contracts: The Balance. Retrieved from https://www.thebalance.com/time-and-materials-contracts-844492
• Unit Price Contracts: Government of the Northwest Territories. (2009). Retrieved from https://www.inf.gov.nt.ca/sites/inf/files/unit_price_contracts.pdf
• The job costing system: Accounting Tools. (2015). Retrieved from https://www.accountingtools.com/articles/what-is-a-job-costing-system.html
• Job Costing in Service Organizations: Saylordotorg. (n.d.). Retrieved from https://saylordotorg.github.io/text_managerial-accounting/s06-01-job-costing-in-service-organiza.html