What Is a Contract Cost and How Is It Determined?

A contract cost represents the total expenditure a business incurs to fulfill the obligations of a specific agreement. These costs are tracked to determine the profitability of a project, justify client billings, and inform financial decisions. In industries like construction or engineering, where projects are unique and often span long durations, understanding these costs is an important element of financial management.

Components of Contract Costs

The total cost of a contract is composed of both direct and indirect costs. Direct costs are expenses that can be specifically identified and traced to a single contract. These include the raw materials consumed, the wages of laborers working exclusively on the project, and equipment rented for the specific job. For example, the cost of lumber and the salaries of carpenters on a home-building project are direct costs.

Indirect costs are expenses necessary for business operations as a whole but cannot be tied to a single project. These costs, often called overhead, include expenses like administrative salaries, office rent, utilities, and general insurance. A portion of these costs must be allocated to each contract using a reasonable and consistent method, such as a percentage of direct labor hours or total direct costs.

Methods for Determining Contract Costs

The way a contract’s final price is determined depends on the pricing structure agreed upon by the parties. There are three primary methods, each suited for different types of projects and levels of scope definition.

A fixed-price contract, also known as a lump-sum agreement, establishes a single, total price for all the work defined in the contract. This model is best used when the project scope is clearly defined and the risk of unforeseen changes is low. The contractor bears the financial risk; if actual costs exceed the agreed price, the contractor’s profit is reduced, but if they complete the work for less, their profit increases. This structure provides cost certainty for the client from the outset.

A cost-reimbursable contract, or cost-plus, involves the client paying the contractor for all allowable costs incurred during the project, plus an additional fee or percentage for profit. This approach is common for projects where the scope is uncertain or involves research and development, as it provides flexibility. The fee can be a fixed amount or an incentive-based amount tied to performance metrics.

A time and materials (T&M) contract is a hybrid model where the client pays a pre-negotiated hourly rate for labor and the actual cost for materials used. T&M contracts are suitable when the project duration or the full extent of the work is not clearly known at the start. To control potential cost overruns, these contracts often include a “not-to-exceed” clause, which sets a maximum price that the client will pay.

Accounting for Contract Costs

The accounting treatment of contract costs is governed by specific standards that dictate how these expenditures are recorded in a company’s financial statements. A primary consideration is whether a cost should be capitalized or expensed. Capitalizing a cost means recording it as an asset on the balance sheet, while expensing a cost means recording it immediately on the income statement.

Accounting Standards Codification 606 introduces two main categories of costs: costs to obtain a contract and costs to fulfill a contract. Costs to obtain a contract are incremental expenses incurred that would not have been paid if the contract had not been secured, such as a sales commission. These costs are capitalized as an asset if the company expects to recover them.

Costs to fulfill a contract are those directly related to the work, like direct labor and materials. These are also capitalized if they generate or enhance resources that will be used to satisfy the contract and are expected to be recovered. For example, the cost of a specific design created for a client’s project would be capitalized.

Managing and Controlling Contract Costs

Managing contract costs begins with establishing a detailed budget, which serves as the financial baseline against which all spending is measured. Continuous tracking of actual costs against the budgeted amounts is necessary to identify variances early. This allows project managers to take corrective action before deviations become significant and involves meticulous record-keeping of all expenses.

A formal process for handling change orders is another component of cost control. Change orders are modifications to the original contract scope, which can arise from client requests, unforeseen site conditions, or design alterations. Each change order must be documented in writing, detailing the impact on cost and schedule, and must be formally approved by both the client and the contractor before work proceeds.

Many contracts also include a contingency fund, which is a pre-approved amount set aside to cover unexpected but necessary expenses. This provides a financial cushion without derailing the project.