A REPORT ON CONTRACT COSTING
A PROJECT REPORT
Submitted by
ASWATHY A S
MZC18MBA10
Under the guidance of
Prof. VISHNU PANKAJASHAN
(Assistant professor Mount Zion School of Business Management)
in partial fulfilment of the requirements for award the Degree of
MASTER OF BUSINESS ADMINISTRATION
of
A P J Abdul Kalam Technological University, Trivandrum
SCHOOL OF BUSINESS MANAGEMENT
MOUNT ZION COLLEGE OF ENGINEERING,
KADAMMANITTA
JANUARY-2020
INTRODUCTION
Contract costing is the method of costing which is applied in a business where separate contracts
of non-repetitive nature are undertaken. According to Sharie, “Contract or terminal cost accounts
are applicable to a concern which makes specific contracts and requires to know the cost of
each.”A contract is a job of large size may extend even beyond one accounting period. The
person executing the contract is known as a Contractor and the person for whom it is executed is
known as [Link] costing is a special form of job costing wherein big jobs are
involved which requires considerable time to complete and comprises a lot of activities. Herein a
separate account is opened for each contract in the Contract Ledger (or in General Ledger). The
account is debited with all direct and indirect expenses and is credited with the amount of contract
price on completion of the contract. The balance of this account is transferred to Profit and Loss
Account. However, if the contract is not completed before the end of the accounting period, a
reasonable amount of profit (or logs) is transferred to Profit and Loss Account.
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.
THEORY ON CONTRACT COSTING
Contract costing is a specialized system of Job costing applies to long-term contracts as distinct
from short-term jobs. Contract costing is mainly applied in civil construction and engineering
projects, ship building, road and railway line contracts, construction of bridges etc.
Contract costing is a form of Specific order costing. It is applied to contracts where substantial
time is taken to complete the contract and it falls into different accounting periods. However, a
duration of exceeding one year is not an essential feature of a long-term contract. Some contracts
with a shorter duration than one year should be accounted for as long-term contracts if they are
sufficiently material to the activity of the period.
CIMA defines Contract cost and Contract costing as follows:
“Contract cost is the aggregated costs relative to a single contract designated a cost unit”.
“Contract costing is that form of specific order costing which applies where work is undertaken
to customers’ special requirements and each order is of long-term duration
(a) Contracts are undertaken to special requirements of the customers.
(b) Duration of contracts are relatively for a long period.
(c) Contract work is done on the sites unlike manufacturing under a roof.
(d) Contract work mainly consists of constructionactivities.
Format of contract costing
Profit or Loss Account:
The balance of Contract Account represents profit or loss which is transferred to
Profit and Loss Account. However, when contract is not completed within the
financial year, only the part of the profit arrived is taken into account and the
remaining profit is kept as reserve to meet any contingent loss on the complete portion
of the contract.
Computation of Profit or Loss on Contract:
There may be three situations in the computation of profit or loss on contracts.
They are:
(I) Profit on completed contracts,
(II) Profit on uncompleted contracts,
(III) Profit on likely to be completed contracts.
I. Profit on Completed Contracts:
If a contract is begun and completed in the same financial year, then, the entire profit
or loss made on such a contract should be transferred to the Profit and Loss Account.
If there is profit, the same should be credited to the Profit and Loss Account and debit
should be given to Contract Account. On the other hand, if there is loss, the same
should be debited to the Profit and Loss Account and credit being given to the
Contract Account.
II. Profit on Uncompleted Contracts:
Contracts which are started and finished during the same financial year create no
accounting problems. But in case of those contracts which take more than one year to
complete, a problem arises whether profit on such contracts should be worked out
only on the completion of the contract or at the end of each financial year on the
partly completed work. If profit is computed only on the completion of the contract,
profit will be high in the year of completion of the contract, where as in other years of
working on contract, profit will be nil.
This would result not only distorted profit pattern but also higher tax liability because
income-tax at higher rates may have to be paid. Therefore, when contracts extend
beyond a year, it becomes necessary to take into account the profit earned or loss
incurred oh the work performed during each year. This helps in avoiding distortion of
the year-to-year profit trend of the business.
There are two aspects of the profit computation:
(1) Computation of notional profit or estimated profit, and
(2) Computation of the portion of such profit to be transferred to Profit and Loss
Account.
The portion of the notional or estimated profit to be transferred to Profit and Loss
Account depends upon the stage of completion of the contract. Prudence requires that
the total notional profit should not be transferred to Profit and Loss Account but a
portion of it should be withheld as a reserve to meet any unforeseen future expenses
or contingencies.
However, the following general rules may be followed in this context:
1. First Rule:
When work certified is less than 1/4 of the contract price, no profit is transferred to
Profit and Loss Account. This is based on the principle that no profit should be taken
into account unless the contract has reasonably advanced.
2. Second Rule:
When work certified is 1/4 or more but less than 1/2 of the contract price, then
generally 1/3 of the profit is transferred to Profit and Loss Account. The balance
amount is treated as reserve. Thus, profit to be transferred to Profit and Loss Account
is computed by the following formula –
3. Third Rule:
When work certified is 1/2 (i.e. 50%) or more but less than 9/10 (i.e. 90%) of the
contract price, then the profit to be transferred to Profit and Loss Account is computed
by the following formula –
4. Fourth Rule:
When contract is near completion then the estimated profit should be calculated on
the whole contract. The proportion of estimated profit to be transferred to Profit and
Loss Account is computed by any one of the following formulas:
5. Fifth Rule – Loss on Uncompleted Contracts:
In the event of a loss on uncompleted contracts, this should be transferred in full to
the Profit and Loss Account. Whatever be the stage of completion of the contract.
6. Cost Plus Method of Contract:
Cost plus method of contract is that where contract price is not settled between
contractor and contractee, but it is agreed that contractor will be paid a fixed
percentage of profit on the total cost incurred by contractor on and above the total cost
of the work done. Such type of contract is entered into in war time or time of
economic fluctuation or where contract is to be executed in urgency and it is difficult
to quote the price of the contract.
The following expenses were incurred on an unfinished contract during the year 2015.
Materials ` 90,000
Wages ` 60,000
Other expenses ` 30,000
` 2,00,000 was received by the contractor, being 80% of the work certified. Work done
but not certified was ` 5,000. Determine the profit to be credited to profit and loss account and
profit kept reserve in all the three alternatives given below:
(i) Contract price is ` 3,00,000
(ii) Contract price is ` 5,50,000
(iii) Contract price is ` 12,00,000
Particulars Particulars
To materials 90,000 By working progress 2,50,000
To wages 60,000
Other Expenses 30,000 By work uncertified 5000
Notional profit 75000
2,55000 2,55000
When contract price is ` 3,00,000, work certfied is
2,50,000
3,00,000 × 100 = 83.33% of the
contract price. As it is more than 50% of the contract price, profit credited to P&L
A/c is
Notional profit × 2/3 × 80%
= 75,000 × 2/3 × 80% = ` 40,000
Profit in reserve = ` 75,000 – 40,000 = ` 35,000
(ii) When contract price is ` 5,50,000, work certfied is
2,50,000
5,50,000 × 100 = 45.55% of the
contract price. As it is less than 50%, profit to be credit to P&L A/c is
Notional profit × 1/3 × 80%
= 75,000 × 1/3 × 80% = ` 20,000
Profit in reserve = ` 75,000 – 20,000 = ` 55,000
When contract price is ` 12,00,000, work certfied is
2,50,000
12,00,000 × 100 = 20.83%. As
it is less than 25% of the contract price, no profit is credited to P&L A/c and the entire
amount of notional profit is to be kept in reserve