Contract Costing

Concept Explanation Document Presented By: Vikram Joshi 56 Deep Waghela 57 Monalisa Wardhan 58

Contract Costing AGENDA

Contents
1. 2. 3. 4. 5. 6. 7. 8. Introduction .................................................................................................................................... 3 Distinction between contract and job costing ................................................................................ 3 Features of Contract Costing .......................................................................................................... 4 Contract Costing Procedure ............................................................................................................ 4 Special points in Contract costing ................................................................................................... 5 Calculation of profit ........................................................................................................................ 8 Escalation clause ........................................................................................................................... 10 Cost-plus contracts ....................................................................................................................... 11

2|Page

Contract Costing
1. Introduction

Contract Costing, also known as terminal costing is a variant of job costing. Each contract is a cost unit and accordingly an account is opened for each contract to accumulate the corresponding profit/ loss. Contract costing is the method of costing used to find In out the cost and costing, profit of the each contract is for a given period. to

Contract

work

undertaken

customers special requirement and order is of a longer duration. Contract work is carried out at site which is different from factory

premises used in job costing. Contract costing enables the contractor to ascertain and control the cost of each job or contract. Contract costing is applicable to: Civil construction works like building contractors, dam, roads Civil engineering firms like building repairing firms, landscaping firms etc. Mechanical engineering firms ship building, aircraft building and the like

2. Distinction between contract and job costing

The difference between contract and job costing is as follows: 1. The jobs undertaken at a time are usually high as compared to number of contracts because contracts are bigger in size. 2. In contract costing, most of the costs are directly chargeable to contract accounts. Under Job costing, direct allocation is not possible to such an extent. 3. Overhead costs allocation and apportionment is simpler in contract costing as compared to job costing. 4. Jobs are carried out in factory premises while contracts are undertaken at sites. 5. Contract costing is used in building construction, road construction, bridge construction etc. while Job costing is used in Printing press, interior decoration, automobile repair shop, machine tools etc.

3|Page

Contract Costing
3. Features of Contract Costing
1. Contracts are usually larger in size; hence number of contracts undertaken is generally smaller in number. 2. A contract generally takes more than a year to complete. 3. Contracts are carried out at the site of the contracts and not in factory premises. 4. Each contract undertaken is a cost unit. 5. A separate contract account is prepared for each contract in the books of the contractor to ascertain profit or loss on each contract. 6. Most of the materials are specially purchased for each contract. These are directly charged from the suppliers invoices. Any materials drawn from the store is charged to contract on the basis of material requisition notes. 7. Nearly all labour is direct. 8. Most expenses like electricity, telephone, insurance etc are direct. 9. Specialist sub-contractors may be employed for electrical fittings, welding, glass etc 10. Plant and equipment may be purchased or hired for the duration of the contract. 11. Payments by contractee are made at various stages of contract based on architects certificate for the completed stage. Retention money is withheld by the contractee as per the agreed terms. 12. Penalties may be incurred by the contractor for failing to complete the work within agreed period.

4. Contract Costing Procedure

The procedure for contract costing is as follows: 1. Contract Cost: Each contract is allocated a distinct number and a separate account is opened for each contract. 2. Direct Costs: Most of the costs can be allocated directly to the contract. These are debited to the account. Direct costs include a) Materials b) Labour and Supervision c) Direct Expenses d) Depreciation of plant and machinery e) Sub-contract costs etc.
4|Page

Contract Costing
3. Indirect costs: Contract account is debited with overheads, which are smaller as compared to direct costs. These are absorbed as a percentage of prime cost or materials or wages etc. Overheads are restricted to head office and storage costs. 4. Transfer of materials or plant: When materials, plant or other items are transferred from the contract, the contract account is credited by that amount. 5. Contract Price: The Contract account is credited with contract price. When contract is incomplete at the end of the financial year, the contract account is credited with the value of work-in-progress as on that date.
6. Profit or Loss on contract: The balance of contract account represents profit or loss

which is transferred to Profit and Loss account. But, when contract is not completed within the financial year, only a part of the profit arrived is taken into account and the remaining profit is kept as reserve to meet any contingent loss on the incomplete portion of the contract.

5. Special points in Contract costing

The following are some important points under Contract Costing: a. Contractor: Contractor is the person who undertakes the contract (job). b. Contractee: Contractee is the person for whom contract job is undertaken. c. Contract price: Contract price is the amount agreed to be paid by the contractee to the contractor as consideration for the job done. The contract price may be payable in lump sum when work is completed. Alternatively, the amount may be paid in instalments as the work progresses. The amount of each instalment would depend on the amount of work done and certified by the architects. d. Work Certified: In the case of large contract, normally the contractor receives on account payment against the value of the work completed at specific intervals. Work certified is that part of work completed for which the contractor gets the
5|Page

Contract Costing
certificate of the architect. In the case of large contract, the contractor would expect the contractee to make a payment of the contract price in installments. He therefore, sends a part bill to the contractee as and when a portion of the work is completed. An architect, appoint in terms of the contract, between the contractor and contractee, scrutinizes the part bill, he certifies the work done for the purpose of payment. The work certified is related to the contract price and not to the cost of the work done. Suppose the contract price is Rs. 10 lacs, and the cost incurred to date by the contractor is Rs. 4 lacs. If half the work is done and certified, then the value of work certified will be half of Rs. 10 lacs, i.e. Rs. 5 lacs. The value will have nothing to do with cost-to-date of the work done. Therefore, Work Certified = Cost of Work Certified + Profit

e. Work Uncertified: Work uncertified is that cost of work done which relates to the period between the date of work certified and accounting year ending. At the end of the accounting period, not all work done would have been certified by the architect. This would be so because the bill itself would not have been submitted by the contractor. Suppose the accounting period ends on 31st December. The contractor would have submitted his bills which would probably include all expenses incurred by him up to 10th December and this might be certified for the payment by the architect. The expense incurred by the contractor between 11th December and 31st December is the cost of work uncertified; this amount is always with reference to its cost and not at contract price as compared to the work certified which is at selling price. f. Cost of materials: Materials include: i. Materials specifically purchased for the contract ii. Materials issued from store against requisition notes The cost of both these types of materials is debited to the contract account. Whenever materials are issued in excess of requirements, these are later

6|Page

Contract Costing
returned to the store accompanied by a material return note. Such returned materials are credited to the contract account. At the end of each accounting period, value of materials lying unused at site is credited to contract account and is carried forward for charging against the next period. g. Cost of labour: All wages of workers engaged on a particular contract are charged direct to the contract irrespective of the type of work they perform. When several contracts are running at different locations, payroll is normally sectionalized so as to have separate payroll for each contract. h. Plant: There are two different methods of dealing with depreciation of plant in contract account: i. Contract account is debited with the cost of the plant installed. When the contract is completed or the plant is no longer required, the plant is revalued and contract account is credited with the revalued or depreciated figure. This method is generally used on long contracts which extend over more than one year. ii. On the other hand, contract account is simply debited with the amount of depreciation. It is usual to use this method when the plant is sent to contract only for a short period. i. Sub-contracts: Work of specialized character for which facilities are not internally available is offered to a sub-contractor. For example, steel work, glass work, painting, etc. is usually carried out by the sub-contractors who are accountable to the main contractor. The cost of such work is charged to the contract account. j. Payment done: When the contract is small, full payment is usually made on the completion of the contract. But in cases of longer contracts taking more than 1 year to complete, a system of progress payments is followed. In this system, part payments of the contract amount are paid from time to time on the basis of certificate issued by the architects (acting for the contractee), certifying the value
7|Page

Contract Costing
of the work satisfactorily completed. Such payments received by the contractor are usually credited to the personal account of the contractee. These payments are not entered in the contract account. k. Cash Ratio & Retention Money: The contractee usually pays a fixed percentage, say 70% or 80% of the work certified, depending upon the terms of contract. This is knows as cash ratio. The balance amount not paid is the retention money. This retention money is to safeguard the contractees interest in case of future defects in the work done. This also works as a deterrent for the contractor to leave the contract incomplete, if he finds the contract unprofitable. This may also be adjusted against penalties that become due if the contract is not completed within the stipulated time as per the terms of the agreement. l. Extra work: When the contractor is required to do some extra work, the contractor will charge extra money for such extra work. The work could be additions or alterations in the work originally done as per the agreement. The cost of such extra work is debited to the contract account and extra price realized is credited to the contract account.

6. Calculation of profit
Contracts which are started and finished during the same financial year create no accounting problems. However, the 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. Profit determination involves the following computation: Notional profit: Notional profit is the difference between the value of work-in-progress certified and the cost of work-in-progress certified. It is given as follows: Rs.

8|Page

Contract Costing
Value of work certified Add: Cost of work not yet certified Less: Cost of work to date Notional Profit xxxxxx xxxxxx xxxxxx xxxxxx

Estimated profit: Estimated profit represents the excess of the contract price over the estimated total cost of the contract. It is given as follows: Rs. Contract Price Less: Total cost already incurred Less: Estimated additional costs to complete the contract Estimated Profit xxxxxx xxxxxx xxxxxx xxxxxx

Portion of profit to be transferred to P&L account:

The portion of profit to be credited to, profit and loss account should depend on the stage of completion of the contract. This stage of completion of the contract should refer to the certified work only. For this purpose, uncertified work should not be considered as for as possible. For determining the credit for profit, all the incomplete contracts should be classified into the following four categories. Contract less than 25% complete Contracts between 25% and 50% complete Contracts between 50% and 90% complete Contracts nearing completion, say between 90% and 100% complete

The transfer of profit to the profit and loss account in each of the above cases is done as under: Contract less than 25% complete: If the contract has just started or it is less than 25% complete, no profit should be taken into account. Contract between 25% and 50% complete:

9|Page

Contract Costing
In this case one third of the notional profit reduced in the ratio of cash received to work certified, may be transferred to the profit and loss account. The amount of profit to be transferred to the profit and loss account is 1/3(notional profit). Contract between 50% and 90% complete: In this case, two third of the notional profit, reduced by the portion of cash received to work certified may be transferred to the profit and loss account. The amount of profit to be transferred to the profit and loss account is 2/3(notional profit). Contract nearing completion: When a contract is nearing completion or 90% or more work has been done on a contract. The amount of profit to be credited to profit and loss account may be determined by using any one of the following formula: (a) Estimated profit (Work certified/Contract price) (b) Estimated profit (Work certified/Contract price) x (Cash received/Work certified) (c) Estimated Profit (Cost of work to date/Estimated total cost) (d) Notional profit (Work certified/Contract price)

7. Escalation clause
It is a clause which is always provided in a contract to safeguard the interests of the contractor against any rise in price of materials and rates of labour and their increased utilization. If the prices of materials and rates of labour increases during the period of the contract beyond certain defined level, the contractor will be compensated to the extent of a portion thereof. The contractor has to satisfy the contractee about his claim for compensation in respect of prices and utilisation of material and labour. For example, it may state that if the price of steel goes up by 10%, the contract price will increase by 1.5%. This implies that the base prices of inputs should be agreed upon and also that the date after which increase in prices will be taken into account will be fixed. The contractor is not compensated for price changes which could be avoided, for example, by completing the contract on time. It is not necessary that the contractee must agree to the escalation clause; it is a matter of negotiation between the two parties.
10 | P a g e

Contract Costing
8. Cost-plus contracts
Cost-plus contract is a contract in which the contact price is not fixed at the time of entering into the contract. These contracts provide for the payment by the contractee of the actual cost of manufacture plus a stipulated profit, mutually decided between the two parties. The accounts of the contractor are usually subject to audit by the contractee. The main features of these contracts are as follows: 1. The practice of cost-plus contracts is adopted in the case of those contracts where the probable cost of the contracts cannot be ascertained in advance with a reasonable accuracy. 2. These contracts are preferred when the cost of material and labour is not steady and the contract completion may take number of years. 3. The different costs to be included in the execution of the contract are mutually agreed, so that no dispute may arise in future in this respect. Under such type of contracts, contractee is allowed to check or scrutinize the concerned books, documents and accounts. 4. Such a contract offers a fair price to the contractee and also a reasonable profit to the contractor. 5. The contract price here is ascertained by adding a fixed and mutually pre-decided component of profit to the total cost of the work. Cost-plus contracts are usually entered into for executing special types of work like construction of dam, power house, newly designed ships, etc. where accurate cost estimation is difficult. Government often prefers to give contracts on cost-plus terms. Some of the advantages and disadvantages of entering into cost-plus contracts is stated below: a. Advantages (To Contractor): No risk of loss being incurred Protects the risk of fluctuations Simplifies work of preparing tenders & quotations

b. Advantages(To Contractee): Can ensure a fair price of contract by means of auditing the accounts of the contractor

11 | P a g e

Contract Costing
c. Disadvantages (To Contractor): Deprived of advantages due to favourable market prices Contractor suffers due to his own efficiency d. Disadvantages(To Contractee): Pays more for the inefficiency of the contractor Price is unknown until after the completion of work

12 | P a g e