Contract costing serves a vital purpose: to meticulously determine and track the total cost of a specific contract. This information is crucial for assessing the contract’s profitability, justifying billing to the client, and informing key decisions throughout the project lifecycle. It’s a specialized type of job costing typically used in industries that handle large, intricate projects. These industries include construction, engineering, software development, film and entertainment production, and shipbuilding.

Here’s a quick breakdown of this costing method:

  1. Purpose
    Tracks costs for individual contracts to determine profitability, identify areas for cost savings, and ensure the contract price covers all expenses.
  2. Similarities to job costing
    Similar to job costing, contract costing assigns costs to individual projects. However, contract costing deals with significantly larger and longer projects.
  3. Key features
    • Separate accounts are established for each contract to track all direct and indirect costs incurred, contributing to the total contract cost.
    • Costs are accumulated throughout the entire contract duration.
    • Contract costing is frequently used for projects that span multiple accounting periods.

Contract costing isn’t magic – it follows a clear set of steps. Here’s what typically happens:

  • Preparing contract budget. The project budget is meticulously crafted based on estimations of both direct and indirect costs associated with all resources required to complete the project successfully.
  • Allocating costs. Identifying the cost centers associated with the contract and assigning all budgeted costs accordingly. This includes direct costs like materials, labor, and directly attributable expenses, along with indirect costs like overhead and administrative expenses. An appropriate allocation method, such as labor hours or a percentage of direct costs, is used to spread these indirect costs to the specific contract.
  • Recording accumulated costs. Throughout the contract’s duration, all allocated costs are closely recorded. This typically involves a separate cost ledger or a project management system that allows for real-time monitoring and comparison against the initial budget or estimated costs.
  • Analyzing accumulated costs. The accumulated costs are analyzed from time to time to assess the contract’s progress, overall cost-efficiency, and identify areas for potential improvement. This analysis might involve comparing actual costs to budgeted costs, evaluating individual activities or resources, and pinpointing opportunities for cost savings or process enhancements.
  • Finalizing the financials. This stage marks the financial conclusion of the contract. A comprehensive document called the final account is prepared, which serves as a detailed record of all project costs. It carefully compares these final costs to the initial estimates or budget that were established at the project’s outset. This comparison allows for the calculation of the project’s ultimate profitability or any potential losses incurred. The final account serves as a critical document for both the contractor and the employer, ensuring financial transparency and finalizing their financial obligations under the contract.

We’ve covered how contract costing helps keep track of project finances. But there’s more to the story, as not all contract costing methods are created equal!

Types of Contract Costing

Different project scenarios call for different approaches within contract costing. Here are the three main types of contract costing, each with its own risk profile and best suited for various project dynamics.

  1. Fixed price contracts
    • Structure: A predetermined price for the entire project is agreed upon upfront by the contractor and the client.
    • Risk allocation: The contractor bears the risk for any cost overruns.
    • Benefits for client: Guaranteed fixed cost for the project.
    • Drawbacks for contractor: Less favorable for projects with uncertainty or unforeseen circumstances.
  2. Cost plus contract

    • Structure: The contractor is reimbursed for all allowable costs incurred throughout the project, with a predetermined markup or fee added as profit.
    • Risk allocation: The client covers all allowable costs.
    • Benefits for contractor: Flexibility and protection from cost overruns.
    • Drawbacks for contractor: Potential for less cost-consciousness as profit increases with expenses; however, variations like cost plus incentive contracts address this.
  3. Time and material contracts
    • Structure: Payment is calculated based on a predetermined hourly or daily rate multiplied by the actual time spent working on the project.
    • Focus: The amount of time spent delivering the service, rather than a fixed total cost or reimbursable expenses.
    • Benefits: Adaptable to changing project requirements, fair if hourly rate is accurate, and offers clear cost visibility based on time spent.Drawbacks: Total project cost might be uncertain upfront, requires good time tracking to avoid inflated costs, and contractors might have less incentive for efficiency. Note that it can be combined with other elements like maximum time limits or milestone fees.

Example of Contract Costing: Renovating a Restaurant Kitchen (Fixed Price Contract)


Let’s assume a company named ABC Construction is contracted to renovate the kitchen of a restaurant named ‘Grub Eat’. Both parties agree to a fixed price contract.

Project scope 

The scope of work includes:

  • Demolishing and removing old kitchen equipment.
  • Installing new flooring, countertops and ventilation systems.
  • Supplying and installing new ovens, refrigerators and dishwashers (based on a pre-approved equipment list).
  • Completing all plumbing and electrical work required for the new equipment.
  • Painting the kitchen walls and ceiling.

Contract price

ABC Construction and Grub Eat agree on a fixed price of $150,000 for the entire project. This price covers all labor, materials, permits, and other expenses associated with the renovation.

Contract costing for ABC Construction

Here’s how ABC Construction would use contract costing to track project expenses and profitability.

  1. Cost estimation: Before finalizing the contract, ABC Construction would meticulously estimate all the costs associated with the project. This includes:

    • Direct labor: estimated labor hours required for demolition, installation, plumbing, electrical work, and painting, multiplied by the hourly wage rate, including benefits, for each type of worker.
    • Direct materials: Estimated quantities and costs of materials needed for flooring, countertops, ventilation systems, equipment, plumbing and electrical supplies, and paint.
    • Direct expenses: Permits, dumpster rental, temporary power hookup and other miscellaneous project specific costs.
  2.  Cost tracking: Throughout the project, ABC Construction would carefully track all actual contracting costs incurred. This involves:

    • Recording labor hours for each worker assigned to the project.
    • Monitoring material usage and keeping track of any material cost variances from the estimates.
    • Tracking and documenting all direct expenses paid throughout the renovation.
  3. Keeping an eye on costs: ABC Construction would regularly check how much they’re spending compared to their initial estimates. This way, they can catch any cost overruns early on and take steps to fix them, such as:

    • Negotiating with suppliers for lower material costs.
    • Optimizing labor usage to improve efficiency.
    • Identifying and eliminating unnecessary project expenses.
  4. Profitability analysis: When the project is completed, ABC Construction would compare the total actual costs incurred with the fixed price contract value of $150,000. This will determine the project’s profitability:
    • Profit scenario. If the total actual costs are less than $150,000, the difference represents ABC Construction’s profit on the project.
    • Loss scenario. If the total actual costs exceed $150,000, ABC Construction incurs a loss on the project due to the fixed price contract. This is exactly why accurate cost estimation is crucial for fixed price contracts.

Benefits of contract costing for ABC Construction

  • Improved cost management: Helps track expenses throughout the project and identify areas for cost savings.
  • Enhanced profitability: Allows for informed decision making to keep the project on budget and maximize profit.
  • Accurate project pricing: Provides valuable data for future project estimates and competitive bidding.

Note: This is a simplified example. Real-world contract costing involves more complex accounting practices and may include additional cost elements depending on the specific contract.