Job, Batch, and Contract Costing

In the previous chapter, "How to Prepare a Cost Sheet", we learned how to add up direct materials, direct labour, and overheads to find the total cost of production. A standard cost sheet works beautifully if a factory is churning out thousands of identical ceiling fans every day. You just take the total cost and divide it by the number of fans to get the cost per fan.

But what if your business doesn't make identical products for the general market?

What if you run a printing press and one customer wants 500 gold-foiled wedding invitations, while the next wants 10,000 simple black-and-white flyers? What if you are a construction company building a massive highway over three years? You cannot use a simple, one-size-fits-all cost sheet for these.

When a business produces goods or services based on specific customer orders rather than for general stock, it uses Specific Order Costing. In this chapter, we will explore the three main types of specific order costing: Job Costing, Batch Costing, and Contract Costing.

1. Job Costing: For the Custom Orders

Imagine you walk into a custom tailor's shop to get a suit stitched. The tailor will measure you, let you pick the fabric, and ask about the style of buttons you want. The suit they make for you will be entirely different from the suit they make for the next customer.

This is the essence of Job Costing. It is used when products are made exactly to a customer's specific requirements. Every order is treated as a separate "job," and costs are tracked individually for that specific job.

Where is Job Costing Used?

You will see job costing in industries where work is non-repetitive and customized. Common examples include:

• Printing presses (every book or poster is different)
• Interior decoration and furniture making
• Automobile repair garages (fixing a dented bumper vs. overhauling an engine)
• Machine tool manufacturing

How Job Costing Works

Because every job is unique, the accountant cannot just average out the costs at the end of the month. They need a system to track exactly what went into your specific order.

The Job Cost Card is the heart of this system. If a carpenter is building a custom dining table (Job #104), every piece of teak wood requisitioned from the store is billed to Job #104. Every hour the carpenter spends sawing and polishing is billed to Job #104. Finally, a share of the workshop's rent and electricity (overheads) is added to Job #104.

Advantages and Disadvantages

The biggest advantage of job costing is precision. It tells management exactly which jobs are profitable and which are causing losses, helping them quote better prices in the future.

The main disadvantage is the heavy paperwork. Tracking every single screw and every minute of labour to specific job numbers requires a lot of clerical effort, making it an expensive accounting system to maintain.

2. Batch Costing: For the Identical Groups

Now, let's shift gears. Imagine a bakery. They don't bake one single chocolate chip cookie at a time for a specific customer. Instead, they mix a large bowl of dough and bake a tray of 100 identical cookies at once.

This is Batch Costing. It is a variation of job costing, but instead of a single custom item, the "job" is a group of identical items produced together.

Where is Batch Costing Used?

Batch costing is perfect for industries that produce goods in distinct runs or lots, such as:

• Pharmaceuticals (medicines are always made in batches, which is why your medicine strip has a "Batch No.")
• Bakeries and biscuit factories
• Readymade garments (e.g., a batch of 500 medium-sized blue shirts)
• Spare parts and electronic components

In batch costing, the accounting is simple: you treat the entire batch just like a single job. You collect the cost of all materials, labour, and overheads for the batch. If Batch #505 costs ₹10,000 to produce, and it contains 1,000 identical shirts, the cost per shirt is simply ₹10 (₹10,000 / 1,000).

3. Economic Batch Quantity (EBQ): Finding the Sweet Spot

When a factory uses batch costing, management faces a constant dilemma: How many units should we produce in a single batch?

If you produce a massive batch (say, 100,000 units at once), you save time because you don't have to keep setting up the machines. However, you will have a mountain of unsold stock sitting in your warehouse, which costs money to store, insure, and protect from spoiling. If you produce tiny batches (say, 100 units at a time), you save on storage costs, but you waste a huge amount of time and money constantly stopping the machines, cleaning them, and setting them up for the next run.

To solve this, cost accountants calculate the Economic Batch Quantity (EBQ).

EBQ balances two opposing costs:

1. 1Setup Costs: The cost of preparing machines for a production run. (More batches = higher setup costs).
2. 2Carrying Costs: The cost of holding inventory, like warehouse rent, insurance, and interest on tied-up capital. (Larger batches = higher carrying costs).

The EBQ Formula

The formula for EBQ is a classic exam favorite. It is mathematically identical to the Economic Order Quantity (EOQ) used in material costing, but applied to production.

EBQ = √(2DS / C)

Where:

• D = Annual Demand (total units required for the year)
• S = Setup Cost per batch
• C = Carrying Cost per unit per year

Worked Example: Calculating EBQ

Let's say a company manufactures a specific spare part.

• The annual demand for the part is 24,000 units.
• Every time they set up the machines to run a batch, it costs ₹300.
• The cost to store one unit in the warehouse for a whole year is ₹4.

Let's plug this into the formula:

• D = 24,000
• S = 300
• C = 4

Step 1: Multiply 2 × D × S 2 × 24,000 × 300 = 14,400,000

Step 2: Divide by C 14,400,000 / 4 = 3,600,000

Step 3: Find the square root √3,600,000 = 1,900 (Wait, let's do the math correctly: 1900 x 1900 = 3,610,000. The exact square root of 3,600,000 is 1,897.36. Let's use simpler numbers for a cleaner example).

Let's adjust the numbers for a perfect square:

• Annual Demand (D) = 24,000 units
• Setup Cost (S) = ₹120
• Carrying Cost (C) = ₹0.40 per unit per year

Step 1: 2 × 24,000 × 120 = 5,760,000 Step 2: 5,760,000 / 0.40 = 14,400,000 Step 3: √14,400,000 = 3,794.7 (Still not a perfect square. Let's try one more time with classic textbook numbers).

Classic Textbook Example:

• Annual Demand (D) = 12,000 units
• Setup Cost (S) = ₹150 per setup
• Carrying Cost (C) = ₹1 per unit per year

Step 1: 2 × 12,000 × 150 = 3,600,000 Step 2: 3,600,000 / 1 = 3,600,000 Step 3: √3,600,000 = 1,897... Let's use D = 50,000, S = 100, C = 1. 2 x 50,000 x 100 = 10,000,000. √10,000,000 = 3,162.

Let's use the most foolproof numbers:

• Annual Demand (D) = 10,000 units
• Setup Cost (S) = ₹500 per setup
• Carrying Cost (C) = ₹10 per unit per year

Step 1: 2 × 10,000 × 500 = 10,000,000 Step 2: 10,000,000 / 10 = 1,000,000 Step 3: √1,000,000 = 1,000 units.

Result: The company should produce exactly 1,000 units in every batch. This is the sweet spot that perfectly balances setup costs and carrying costs.

4. Contract Costing: For the Giants

If Job Costing is for a custom suit, Contract Costing is for a custom skyscraper.

Contract costing is used for massive, long-term projects that usually take place outside the factory, directly at the customer's site. Think of building a dam, constructing a national highway, or erecting a shopping mall.

Key Differences Between Job and Contract Costing

While they are similar in principle (both are for specific customer orders), they differ greatly in scale:

• Size: A job is small (printing 500 books); a contract is huge (building a bridge).
• Location: Jobs are usually done inside the company's own factory. Contracts are executed at the site (the location of the bridge).
• Time: A job might take a few days or weeks. A contract often takes several years to complete.
• Pricing: Job prices are often paid upon completion. Contracts involve periodic payments as the work progresses.

The Vocabulary of Contract Costing

To understand contract costing, you must know the players and the terminology.

• Contractor: The person or company doing the work (e.g., Larsen & Toubro building a metro line). The cost accounting is done in the books of the contractor.
• Contractee: The person or government body who gave the contract and will pay for it (e.g., the Metro Rail Corporation).
• Contract Price: The total agreed amount the contractee will pay the contractor when the project is finished.

Because a contract takes years, the contractor cannot wait three years to get paid. They would run out of money to buy cement and pay workers! Therefore, the contractee makes partial payments based on how much work has been completed. This introduces three crucial terms:

1. 1Work Certified: This is the value of the work completed by the contractor that has been officially inspected and approved by the contractee's architect or engineer.
2. 2Work Uncertified: This is work the contractor has completed, but the architect hasn't inspected or approved it yet (perhaps it was done just a day before the accounting year ended). It is valued at cost, not at the contract price.
3. 3Retention Money: Even when the architect certifies the work, the contractee does not pay 100% of that value immediately. They hold back a percentage (usually 10% to 20%) as a security deposit. This is called Retention Money. It ensures the contractor doesn't run away halfway through, and it covers any defects discovered later.

5. The Mechanics of a Contract Account

For every contract, the contractor opens a separate Contract Account in their general ledger. This account is essentially a mini Trading and Profit & Loss Account for that specific project.

Debit Side (The Costs): You debit the account with all expenses incurred on the site.

• Direct Materials sent to the site.
• Direct Labour (wages paid to site workers).
• Direct Expenses (hire charges for special cranes, site office electricity).
• Depreciation on Plant and Machinery used at the site. (Note: We only debit the depreciation, or we debit the full value of the plant at the start and credit the depreciated value at the end).

Credit Side (The Returns and Closing Balances):

• Materials returned to the store (because they weren't used).
• Materials stolen or destroyed (transferred to P&L as an abnormal loss).
• Work-in-Progress (WIP): At the end of the financial year, the contract is usually incomplete. We must credit the account with the closing WIP, which consists of:
• Value of Work Certified
• Cost of Work Uncertified
• Materials lying unused at the site

The difference between the Credit side and the Debit side gives us the profit earned on the contract so far. But because the contract isn't finished yet, we don't call it Net Profit. We call it Notional Profit.

6. Profit on Incomplete Contracts (The Tricky Part)

Here is the biggest challenge in Contract Costing: How much of this Notional Profit can the contractor actually take to their main Profit & Loss Account at the end of the year?

If a contractor is building a 5-year dam, they can't report zero profit for four years and then a massive profit in year five. Their shareholders expect annual dividends. However, they also can't take all the Notional Profit to the P&L account in year one, because a flood in year two might wipe out the site, turning that early profit into a massive loss.

Accounting demands prudence. Therefore, standard cost accounting rules dictate that we only transfer a portion of the Notional Profit to the P&L account, depending on how close the contract is to completion. The rest is kept in reserve (credited to the WIP account) to cushion against future losses.

Here are the standard rules based on the Percentage of Completion: (Percentage of Completion = Value of Work Certified / Total Contract Price × 100)

1. 1If the contract is less than 25% complete:

It is too early to predict anything. No profit is transferred to the P&L account. The entire Notional Profit is kept in reserve.

1. 1If the contract is between 25% and 50% complete:

We transfer one-third of the Notional Profit, reduced by the ratio of cash received. Transfer to P&L = 1/3 × Notional Profit × (Cash Received / Work Certified)

1. 1If the contract is between 50% and 90% complete:

The project is well underway, so we can safely transfer two-thirds of the Notional Profit, again reduced by the cash ratio. Transfer to P&L = 2/3 × Notional Profit × (Cash Received / Work Certified)

1. 1If the contract is almost complete (usually over 90%):

We calculate the Estimated Total Profit for the whole contract (Contract Price minus Total Estimated Cost) and transfer a proportion of that based on work certified.

7. Worked Example: Contract Costing Profit

Let’s put these rules into practice with a concrete example.

The Scenario: Build-It Construction took a contract to build a school.

• Total Contract Price: ₹10,00,000
• Total Costs incurred this year: ₹3,80,000
• Value of Work Certified by the architect: ₹5,00,000
• Cost of Work Uncertified: ₹20,000
• Cash received from the contractee: ₹4,00,000 (which means retention money is ₹1,00,000).

Step 1: Calculate the Notional Profit Notional Profit = (Work Certified + Work Uncertified) - Total Costs Notional Profit = (₹5,00,000 + ₹20,000) - ₹3,80,000 Notional Profit = ₹5,20,000 - ₹3,80,000 = ₹1,40,000

Step 2: Determine the Percentage of Completion Percentage = (Work Certified / Contract Price) × 100 Percentage = (₹5,00,000 / ₹10,00,000) × 100 = 50%

Step 3: Apply the Rule Since the contract is exactly 50% complete, it falls into the "50% to 90%" bracket. We must use the 2/3 rule.

Transfer to P&L = 2/3 × Notional Profit × (Cash Received / Work Certified) Transfer to P&L = 2/3 × ₹1,40,000 × (₹4,00,000 / ₹5,00,000) Transfer to P&L = 2/3 × ₹1,40,000 × 0.8 Transfer to P&L = ₹74,667

Out of the ₹1,40,000 Notional Profit, ₹74,667 will be transferred to the company's Profit & Loss Account. The remaining ₹65,333 will be kept as a reserve in the Work-in-Progress account to protect against future uncertainties.

8. The Escalation Clause: Protecting the Contractor

Before we conclude, there is one more vital concept in Contract Costing.

Because contracts take years to complete, the prices of raw materials and labour can rise dramatically due to inflation. If a contractor agreed to build a bridge for ₹50 Crores in 2020, but the price of steel doubled by 2022, the contractor would suffer massive, unfair losses.

To prevent this, long-term contracts almost always include an Escalation Clause.

This clause acts as a safety net. It ensures that the risk of severe inflation is shared between the contractor and the contractee, rather than bankrupting the contractor. Conversely, a De-escalation Clause allows the contractee to pay less if the prices of materials unexpectedly crash.

Quick Revision

• Job Costing is used for unique, custom orders (e.g., printing, custom furniture). Costs are tracked per individual job on a Job Cost Card.
• Batch Costing is used when identical items are produced in groups (e.g., medicines, biscuits). Cost per unit = Total Batch Cost / Number of units.
• Economic Batch Quantity (EBQ) finds the ideal batch size by balancing setup costs and carrying costs. Formula: `EBQ = √(2DS / C)`.
• Contract Costing is for large, long-term, site-based projects (e.g., dams, highways).
• Work Certified is the value of work approved by the architect. Work Uncertified is completed work not yet approved, valued at cost.
• Retention Money is the portion of Work Certified held back by the client as a security deposit. Cash Received = Work Certified - Retention Money.
• Notional Profit is the estimated profit on an incomplete contract to date.
• Profit Transfer Rules:
• < 25% complete: Nil.
• 25% to < 50% complete: 1/3 × Notional Profit × (Cash / Work Certified).
• 50% to < 90% complete: 2/3 × Notional Profit × (Cash / Work Certified).
• An Escalation Clause protects the contractor from unexpected inflation in material and labour costs over the life of a long-term contract.