CONTRACT COSTING
It is one form of application of the principles of job order costing. Contract Costing is a type of
costing used in constructional activities such as construction of buildings, roads, bridges etc. The
person who takes contract for a price is called the Contractor and the person from whom it is
taken is called the Contractee.
ACCORDING TO CHARTERED INSTITUTE OF MANAGEMENT ACCOUNTANTS, LONDON
“Contract costing is a form of specific order costing in which costs are attributed to individual
contracts.”
In contract costing each contract is treated as a cost unit and costs are ascertained separately
for each contract. Usually, there is a separate account for each contract.
FEATURES OF CONTRACT COSTING
EACH CONTRACT ITSELF A COST UNIT
In contract costing, every contract is a cost unit. Each contract has its own list of expenses and
incomes.
WORK IS EXECUTED AT CUSTOMERS SITE
In case of contract costing, the work is performed at a place which is related to the consumer.
For example: The building is constructed on the land of the consumer.
THE EXISTENCE OF SUB CONTRACT
Sometimes the contractor enters into contracts with another contractor to give a portion of work
undertaken by him. In such cases the work performed by the subcontractor s forms a direct
charge to the contract concerned. Sub contract cost will be shown on the debit side of the
contract account.
Sub-contracting may be necessary under the following circumstances:
Work of a specialized nature for which facilities are not internally available within the
concern is offered to a sub-contractor.
It may be advantageous to get a part or component from outside, if it is costlier to
manufacture it.
Consideration of opportunity cost; the management may not like to invest capital which
may be utilized for other more profitable lines.
The capacity of the firm may be limited and in order to keep time schedule, work may be
speeded by offering it to sub-contractors.
WORK IN PROGRESS
It is the unfinished contract at the end of the accounting period and it includes amount of work
certified and amount of work uncertified. Work in progress is an asset, shown in the balance
sheet by deducting there from any advance received from the contractee.
WORK CERTIFIED
The sales value of work completed as certified by the architect is known as ‘work certified’. In the
case of contracts of long duration, the amount payable by the customer to the contractor is based
on the sales value of work done as certified by the architect. At the end of the financial year, the
total sales value of work done and certified by the architect is credited to the contract account.
PROFIT ON INCOMPLETE CONTRACT
At the end of an accounting period it may be found that certain contracts which have been
completed while others are still in process and will be completed in the coming years. The profit
on completed contracts may be safely taken to the credit of the profit and loss account. In the
case of incompleted contracts there are unforeseen contingencies which may lead to heavy
fluctuations in costs and profit. At the same time it does not also seem desirable to consider the
profits only on completed contracts and ignore completely incomplete ones as this may result in
heavy fluctuations in the future for profit from year to year. If profit or loss is not shown in the
intermittent years for the work in progress, contract will show high figure of profit in the year of
completion and reverse may be the case in the year in which a large number of contracts remain
incomplete. Therefore, profits on incomplete contracts should be considered, of course, after
providing adequate sums for meeting unknown contingencies.
WORK UNCERTIFIED
It means work which has been carried out by the contractor but has not been certified by the
architect. Sometimes, work which is complete remains uncertified at the end of the financial year.
The reasons for the same may be
Work not sufficient enough to be certified
Work has not reached the stipulated stage to qualify for certification
It is always valued at cost and credited to the contract account.
RETENTION MONEY
Regardless of the amount of work certified, the contractor is paid a specified percentage of the
same and the balance is held or retained by the contractee. This is because of the fact that the
contractee has to safe guard himself against any contingency arising from the non fulfillment of
the terms of the contract by the contractor. The unpaid balance of work certified or the amount
held back or retained by the contractee is known as ‘retention money’.
SUB CONTRACT
Sometimes the contractor enters into contracts with another contractor to give a portion of work
undertaken by him. In such cases the work performed by the subcontractor s forms a direct
charge to the contract concerned. Sub contract cost will be shown on the debit side of the
contract account.
ESCALATION CLAUSE
This is clause which is provided in the contract to cover up any increase in the price of the
contract due to increase in the prices of raw material or labour or in the utilization of any other
factors of production. If material and labour utilization exceeds a particular limit, the customer
agrees to bear the additional cost occasioned by excessive utilization. Here, the contractor has to
satisfy the customer that excessive utilization is not the result of decreased efficiency.
PREPARATION OF CONTRACT ACCOUNT
A contract account is a nominal account in nature. It is prepared to find out the cost of contract
and to know profit or loss made on the contract. A contractor may undertake a number of
contracts at a time. For each contract a separate account is opened. In the contract account all
direct cost such as material, labour and other direct expenses incurred during an accounting
period are debited and the indirect expenses are apportioned on an equitable basis. The
differences between the two sides are known as Notional profit or notional loss.
CONTRACT
COSTING
TYPES OF CONTRACTS
Generally there are three types of contracts:
Fixed price contracts: Under these contracts both parties agree to a fixed contract price.
Fixed price contract with Escalation clause
Cost plus contract: Under this contract no fixed price could be settled for a contract.
TREATMENT OF PROFIT ON INCOMPLETE
CONTRACTS
At the end of an accounting period it may be found that certain contracts which have been
completed while others are still in process and will be completed in the coming years. The profit
on completed contracts may be safely taken to the credit of the profit and loss account. In the
case of incompleted contracts there are unforeseen contingencies which may lead to heavy
fluctuations in costs and profit. At the same time it does not also seem desirable to consider the
profits only on completed contracts and ignore completely incomplete ones as this may result in
heavy fluctuations in the future for profit from year to year. If profit or loss is not shown in the
intermittent years for the work in progress, contract will show high figure of profit in the year of
completion and reverse may be the case in the year in which a large number of contracts remain
incomplete. Therefore, profits on incomplete contracts should be considered, of course, after
providing adequate sums for meeting unknown contingencies.
There are no hard and fast rules regarding calculation of the figures for profit to be taken to the
credit of profit and loss account. However, the following rules may be followed:
(i) Profit should be considered in respect of work certified only, work uncertified should always be
valued at cost.
(ii) No profit should be taken into consideration if the amount of work certified is less than 1/4th of
the contract price because in such a case it is not possible to foresee the future clearly.
(iii) If the amount of work certified is 1/4th or more but less than 1/2 of the contract price, 1/3rd of
the profit disclosed as reduced by the percentage of cash received from the contractee, should
be taken to the profit and loss account or
Profit =1/3 x Notional Profit x {Cash received / Work certified}
The balance be allowed to remain as a reserve.
(iv) If the amount of work certified is 1/2 or more of the contract price, 2/3rd of the profit
disclosed, as reduced by the percentage of cash received from the contractee, should be taken
to the profit and loss account.
Profit= 2/3 x Notional Profit x {Cash received / Work certified}
The balance should be treated as reserve.
(v) In case the contract is very much near to completion, if possible the total cost of completing
the contract should be estimated. The estimated total profit on the contract then can be
calculated by deducting the estimated cost from the contract price. The profit and loss account
should be credited with that proportion of total estimated profit on cash basis, which the work
certified bears to the total contract price.
Profit=Estimated total profit x {Work certified / Contract price}
(vi) The whole of loss, if any, should be transferred to the profit and loss account.
That part of the profit which is not credited to the profit and loss account is treated as a reserve
against contingencies and is deducted from the amount of work-in-progress for balance sheet
purpose. It is carried down as a credit balance in the contract account itself, the work-in-progress
being represented by the debit balance in the contract account.
The treatment of profit on incomplete contract will be computed as per specific instruction of
problem. If there is no specific instruction then above rules should be applied.
Contract Costing Problem 1:
From the following particulars relating to a contract,
prepare (a) the Contract Account, (b) Contractee’s
Account and (c) relevant entries in the Balance Sheet:
The contract price has been agreed at Rs.2,50,000. Cash has been
received from the contractee amounting to Rs.1,80,000.
Contract Costing Problem 2:
ADVERTISEMENTS:
The following information relate to contract 100 as at 31st
Dec. 1998:
The contract value is Rs.5, 50,000. From the above information
prepare the Contract Account for the year ended 31st December,
1998 clearly showing the profit for the year. Value of work certified
by the architect was Rs.1, 37,500 and the contractor had made
progress payments of this amount less 15% agreed retention
percentage.
Contract Costing Problem 3:
Calculate profit on work certified, cost of work in progress at the year end from the
following:
(a) Materials sent to site Rs.86,000;
(b) Labour on site Rs.70,000;
(c) Plant at site Rs.80,000;
(d) Direct Expenses Rs.3,000;
(e) Office expenses Rs.4,000;
(f) Materials returned to stores Rs.600;
(g) Work certified Rs.1,90,000;
(h) Work not certified Rs.7,700;
(i) Materials in stock at end Rs:2,000;
(j) Outstanding wages Rs.300;
(k) Cash received against bill Rs.1,61,500;
(l) Depreciation on plant Rs. 7,000.
Contract Costing Problem 4:
X & Y Construction Company undertook the construction of a bridge. The value of the
contract was Rs. 25,00,000 subject to a retention money of 20% until one year after the
certified completion of the contract and final approval of the contractee’s engineer. The
following are the details as shown in the Books on 30. 6. 1987:
Contract Costing Problem 5:
ADVERTISEMENTS:
Calcutta Construction Ltd. undertook a contract for
construction of a bridge on 1st July, 1991. The contract
price was Rs.5,00,000. The Company incurred the
following expenses up to December, 1991:
Depreciation 10% p.a. on plant
Charge other works expenses @ 20% of wages and office expenses
@ 10% of works cost.
The amount certified by the engineer was Rs.3,00,000, retention
money being 20% of the certified value.
Prepare the Contract Account showing therein the amount of profit
that the company can reasonably take to its Profit and Loss
Account.