Chapter –2
Contract Costing
Chapter outcomes:
1. Meaning of contract costing;
2. Features of contract accounts;
3. Types of contracts;
4. Costs of contract;
5. Recording of Value and Profit on contracts;
6. Valuation of work-in-progress;
7. Practical exercises;
Meaning of Contract costing
Contract costing is that form of specific order costing which
applies where the work is undertaken according to customer’s
requirements and each order is of long duration as compared to
job costing.
The work is generally of constructional and repairs nature. A
construction account is a contract for the construction of an
asset or of a combination of assets which together constitute a
single substantial project. This covers various activities as
construction of plants, bridges, roads, dams, ships, buildings,
complex pieces of equipment, production of motion picture etc.
that is why this method is used by builders, civil engineering
contractors, constructional and mechanical engineering firms
etc. there contracts are negotiated in a number of ways.
Features of contract account
The work to be executed depends upon customer’s specification
and is generally done at site. Each contract is treated as cost
unit and is generally of long duration for completion. Most of
the expenses are direct in nature and payment is received
depending on the stages of completion of work. The
following are the main features of contract accounts:
1.
2.
3.
4.
Higher proportion of direct costs
Low indirect costs;
Difficulties of cost control;
Surplus materials
Comparison between job and contract costing
There are certain similarities in job and contract costing. Both
the methods belong to the category of specific order costing in
which work is executed according to the specification of
customers. Under both the methods customers come on their
own and there is no need of creating demand. Generally
quotation price is asked before giving order and production
starts only on receipt of order from the customer. As every job
and contract is dissimilar in nature and is identified by a separate
number and is known by that number until it is completed. Profit
is determined in respect of each job and contract separately.
In spite of the above similarities there are certain differences
between job and contract costing.
Differences between job and contract costing
1. Size – a job is a small in size but the contract is big in size;
2. Place of work – work under job costing is performed in the
workshop of the proprietor but the contract is executed mostly at
site;
3. Time for completion – a job usually takes less time for completion
of work whereas a contract takes more time to complete the work;
4. Payment of price – the selling price of a job is paid in full after
completing the job but in case of a contract, the price is paid in
various instalments depending upon the progress of work;
5. Investment – there is heavy investment on assets initially in case of
job costing as compared to contract costing;
6. Nature of expenses – in job costing, expenses may be direct and
indirect but in case of contract costing, most of the expenses are
direct in nature
Types of contracts
Generally there are three types of contracts:
1. Fixed price contracts – under these contracts both parties
agree to a fixed contract price;
2. Fixed price contracts with escalation clause;
3. Cost plus contracts – under these contracts no fixed price
could be settled. The contractor is reimbursed for allowable
or otherwise defined costs plus a percentage of these costs
or a fixed fee towards profit.
Elements of contract cost
The following are the main elements of contract cost in process costing:
1. Materials – materials purchased directly or supplied from the store
or transferred from other contracts will appear on the debit side.
Materials returned to store will appear on the credit side. Amount
received from the sale of surplus materials will appear on the credit
side, any profit or loss arising from the sale will be transferred to
profit and loss account.
2. Labour or wages – all labour employed at the contract site should
be regarded as direct labour and charged direct to the contract
concerned. Where possible, separate wage sheets should be
prepared for each contract.
3. Site expenses – all site expenses other than materials and wages are
charged to individual contract as and when they are incurred
4. Indirect expenses – there are certain expenses which cannot be
directly charged to contracts (eg. Engineers, surveyors,
supervisors, etc). Such expenses may be distributed on several
contracts on some suitable basis as a percentage of materials or
labour;
5. Plant and machinery – careful records of plant and machinery
must be maintained to ensure that none is lost or improperly
disposed of and that the contract is duly charged for the use of
plant
Recording of value and profit on contract
1. Certificate of work done:
When a contractor is engaged on a contract for a considerable
time, his financial resources could be come severely strained.
A large amount of working capital would be required if he did
not receive payment until the completion of the contract. It is
a normal practice particularly in the case of large contracts for
the contractee to pay the contract sums of money on account
during the period of the contract. These sums will be paid
against certificates by surveyors or architects acting for the
contractee certifying the value of work so far performed. This
is known as work certified.
2. Profit on uncompleted work:
Large contracts take a number of years to complete. So their cost
can be ascertained only when they are completed. Even after the
contract is completed, a proportion of contract price may be still
outstanding from the contractee. So it is not possible to ascertain
the profit or loss till the contract is completed and the period
fixed for the payment of retention money has expired. Therefore,
it is felt desirable to take into account a reasonable proportion of
the notional profit on uncompleted contract depending upon the
completion stage subject to the following principles:
(i) For contract which have just started – No profit should be
taken in respect of contracts which have just commenced, as it is
impossible to foresee clearly the future position. Generally, if the
work completed is 1/4th or less than 1/4th of the total work, no
profit shall be transferred to the profit and loss account.
(ii) For contracts which have sufficiently advanced and covered by
architect’s certificate – In this case, notional profit is ascertained by
deducting the cost of the contract covered by surveyor’s certificate
from the value of contract certified by the surveyor. A portion of
notional profit is taken to profit and loss account and the balance is
carried forward in the same contract as a profit in suspense as a
provision against future losses, increase in costs and other
contingencies. The practice for this is that only 1/3rd of the notional
profit is taken, if the completion stage is more than 1/4th complete but
less than ½ and 2/3rd, if the completion stage is between 50 and 90
percent. Sometimes, to be more conservative, the amount of profit is
further reduced in the ratio of cash received to the value of work
certified. The formula for computing the proportion of profit is:
Notional profit X2/3 X (cash Received/Work certified)
(iii) For
the contracts which are almost complete – if the work is
nearing completion , between 91% and 99%, the estimated
profit is ascertained deducting the aggregate of costs to date
and additional expenditure to be incurred to complete the
contract from the contract price. A portion of this estimated
total cost is credited to profit and loss account. This
proportion is ascertained by adopting any one the following
formulae:
(a)Estimated profit X work certified / contract price;
(b)Estimated profit X work certified / contract price X Cash
received /work certified:
(c)Estimated profit X Cost of work to date / estimated total cost;
(d)Estimated profit X Cost of work to date / estimated total cost
X Cash received /work certified
(e)Notional profit X work certified / contract price