Contract Costing

Definition and Concept of Contract Costing:

The term contract costing is used by contractors, builders and engineers, who undertake
definite contracts such as building construction, ship building, bridge construction and so on.
A contract is usually undertaken for a fixed period and price (called contract price), which is
payable either on the completion of the contract or by instalments according to the progress
of work done.
According to CIMA terminology the term ‘contract costing’ refers to “the form of specific
order costing which applies where work is undertaken to customer’s special requirements
and each order is of long duration (compared with those to which job costing applies). The
work is usually constructional and in general the method is similar to job costing”.
So it is a special type of job costing where the unit of cost is a single contract and separate
distinguishing numbers are allotted for each contract to collect cost.

Where is contract costing method used?

The contract costing method is used mostly by builders, civil contractors, ship builders, and
construction and mechanical engineering firms. Generally, the contract is undertaken at the
site of contract i.e. customer and according to the specifications of customer. More over, the
period inquired to complete a contract is fairly long time or usually more than one year.
The main purpose of preparing contract account is the ascertainment of cost of each contract
separately and profit on each contract.

Features of Contract Costing:

The salient features of contract costing are:

(i) The work is generally carried out at a site and not in the factories.

(ii) Each contract is given a distinguishing number in respect of which cost is ascertained.

(iii) It is the contract between the contractor and contractee.

(iv) Many contracts require more than one accounting year.

(v) Most- of the items of cost are directly chargeable to individual contract.

(vi) More often, one contract differs from others.

(vii) Part payments are made depending on the certificate issued by the architect, showing
value of work completed and retention money.

(viii) An “escalation clause”, under which the contractor is compensated for increase in costs
on account of inflation, may be included in the contract.

(ix) In case of non-fulfillment of contract within the stipulated time, the contractor is required
to pay penalty.

Procedure of Contract Costing:

In contract costing, most of the expenses are direct in nature as in the form of materials, labour,
expenses, plant, sub-contract charges and the like. Only a small portion of amount is charged
as overheads which are apportioned on suitable basis. Accounting treatment of costs of
contract costing is briefly explained below.

1. Materials:
The value of materials used is debited in the concerned contract account. Materials may be
specifically purchased from the open market, issued from the stores, transfer from other
contracts or supplied by the contractee himself. If materials are returned to stores, the value of
materials is credited in the concerned contract account.
Sometimes, materials may be transferred from one contract to another. If so, the value of
materials is debited in the receiving contract account and credited in the transferring contract
account.

2. Labour:
Generally, the contract is carried on only at the site of the contractee i.e., customer not within
the company premises. Hence, labour is engaged at site to work on the contract. The amount
paid to workers is wages which is directly debited in the concerned contract account.

3. Direct Expenses:
The direct expenses are debited in the concerned contract account as and when they are
incurred. Examples of direct expenses are hire charges paid for the plant procured from
outside, sub-contractor’s charges, architect’s fees, electricity, insurance and the like.

4. Plant and Machinery:

The plant and machinery is treated in two ways. Under first method, the full value of plant
and machinery is debited in the concerned contract account if the plant and machinery is
specifically purchased for the contract. At the end of contract, the plant and machinery may be
sold out in the market if it is not required further. If so, the sale proceeds are credited in the
concerned contract account.
Sometimes, the plant and machinery may be required further, if so, the depreciated value or
revalued amount of plant and machinery is credited in the concerned contract account. The
net effect is that the contract account is debited with the amount of depreciation.
Under second method, the contract account is debited with the amount of depreciation of plant
and machinery. The plant and machinery may be purchased specifically from the open market
or issued from the stores. The amount of depreciation is calculated on the basis of daily use or
hourly basis. Sometimes, a plant is procured on hire basis, if so, only hourly charges are debited
in the contract account.

5. Overheads:
Indirect costs cannot be directly charged to any contract account. These costs are apportioned
to all the contract accounts only on the suitable basis. These are called as overheads. The term
overheads includes payment made to engineers, supervisors, architects, managers, store
keeper, central office, administrative expenses like staff salaries, telephone expenses, postage,
rent, stationery, advertisement expenses etc.

6. Sub-Contract Charges:
Sometimes part of the contract work is given on subcontract basis and payments made on
subcontract work is debited to Contract Account.
Some Terminology and their Treatment for Contract Costing:

(A) Surveyor’s Certificate and Retention Money:

In case of large contract which extends for more than a year it is normal practice to make
payment against the portion of the contract completed on the basis of work certified by the
contractee’s surveyor. The certificate issued by the surveyor (or technical assessor) in this
respect is known as Surveyor’s Certificate.
Generally, as per terms of the contract, full amount of the work certified is not paid to the
contractor. A certain percentage (say 10% to 20%) of the amount is retained by the contractee
and is paid sometime after the completion of the contract.
The sum of money thus retained is known as Retention Money. This is done to give
protection to the contractee in case the contractor does not fulfill the terms and conditions of
the contract.

(B) Uncertified Work:

The work which has been done by the contractor but not certified by the architect on the date
of accounting due to insufficient progress is known as Uncertified Work.
In case of incomplete contract for which profit is required to be calculated, the value of
uncertified work should be taken into account and it is justifiable to evaluate such work at
cost. Because, it is not logical to calculate profit on the work which is not complete.
Thus the Contract A/c is credited with this cost of uncertified work and Work-in-progresses
debited with the same. This entry is reversed at the beginning of the next year.

Types of Contract:
Work-in-Progress Contract:
Work-in-progress means incomplete contract which is in progress. The contractor may
prepare a Work-in-progress A/c by debiting the account with the value of work certified and
cost of uncertified work and by crediting the profit not transferred to Profit & Loss A/c (i.e.
reserve profit). The difference between the two sides of the account less cash received is the
work-in-progress, which is shown in the Balance Sheet.

Cost-Plus-Contract:
It is the reverse of a fixed price contract. Here the contractor is paid the actual cost incurred
plus a certain percentage of profit over the cost of production. Generally, it is provided in the
agreement as to items of expenditure to be included in the actual cost and the percentage of
profit to be added to the actual cost.
This type of contract is suitable in those cases where probable cost of the contract cannot be
estimated with a reasonable degree of accuracy in advance due to various reasons (such as
longer duration, wide fluctuation in price etc.).
Government contracts (such as dams, bridges, power house, aircraft etc.) are usually on cost-
plus basis. The books and documents of the contract shall remain open for checking and
verifying by its customers. The cost-plus contracts have some advantages and disadvantages
for both the parties to the contract.
Proforma of Contract Account:
Escalation Clause:
In order to avoid the element of risk from both sides—contractor and contractee, there may
be escalation clause in the contract providing for change in price of the contract due to
change in the utilisation of factors of production beyond an agreed level.
In other words, this is a clause which is provided in the contract to cover up any changes in
the price of contract due to changes in price of raw materials and labour or change in
utilisation of factor of production. The object of this clause is to safeguard the interest of both
sides against unfavourable change in the price.
Thus in a contract with the transport undertaking, the price per ton-mile will increase or
decrease for each rise or fall of price of petrol by 10% of the prevailing price. Here the
contractor has to produce sufficient proof of excess cost before the customer agrees to
reimburse such costs. Moreover, the basis on which the factor prices are based, is laid down
in the contact.
In case the escalation clause is extended to increased consumption or utilisation of quantities
of materials or labour, the contractor has to satisfy the contractee that the increased
utilisation is not due to his inefficiency. This clause may also stipulate that in the event of
prices going down beyond an agreed level, the contractee would be entitled to a rebate. This
is termed as De-escalation Clause.

Effect of Escalation Clause on Contract Costing:

Increase in price due to inflation is a common feature of today. Generally, a contract takes
longer duration to complete and during this period the price of material, labour, plant, may
increase beyond a point. In such case the clause, which safeguards the interest of both the
contractor and the contractee against unfavourable price change in future, is called Escalation
Clause.
By virtue of this clause, the contractee has to bear the additional cost arising out of such
inflation. Such clause may also apply where material and labour utilization exceeds a
particular limit. Often there might be a De-escalation or Reverse Clause, providing for
reduction in the contract price and passing on the benefit to the contractee.
Guidelines for Profit and Loss on incomplete Contract:
The contract started and finished within the financial year poses no problem. But big
contracts may extend over more than one accounting year and in that case it is very difficult
to ascertain profit with precision until and unless they are completed. This method cannot be
followed because this would lead to wide fluctuations in profits every year.
Such a fluctuation is not desirable from the viewpoint of payment of dividends to the
shareholders, payment of income-tax etc. So it is desirable to determine profit of incompleted
contract carefully and cautiously so that a reasonable portion of the same should be credited
to the Profit & Loss A/c every year. The “reasonable profit” may vary depending upon the
practice and circumstances of the case.

Illustration 1:
Dulex Limited undertook a contract for 5,00,000 on 1st July, 2006. On 30th June, 2007 when
the accounts were closed, the following details about the contract were gathered:
The above contract contained an escalation clause which read as follows:
“In the event prices of materials and rates of wages increase by more than 5%, the contract
price would be increased accordingly by 25% of the raise in the cost of materials and wages
beyond 5% in each case.”
It was found that since the date of signing the agreement the prices of materials and wages
rates increased by 25%. The value of the work does not take into account the effect of the
above clause.
Prepare the contract account. Working should form part of the answer.

The key points on the standard are:

“The overriding principle being that there can be no attributable profit until the outcome of a
contract can reasonably be foreseen. Of the profit which in the light of all the circumstances
can be foreseen with a reasonable degree of certainty to arise on completion of the contract
there would be regarded as earned to date only that part which prudently reflects the
amount of work performed to date.
The method used for taking up such profits need to be consistently applied.”

The standard continues by elaborating on the profit calculation as follows:

“In calculating the total estimated profit on the contract, it is necessary to take into account
not only the total costs to date and total estimated further costs to completion (calculated by
reference to the same principles as were applied to cost to date) but also the estimated future
costs of rectification and guarantee work and any other future work to be undertaken under
the terms of the contract.
These are then compared to the total sales value of the contract. In considering future costs it
is necessary to have regard to likely increases in wages and salaries to likely increases in the
prices of raw materials and to rises in general overheads so far as these items are not
recoverable from the customer under the terms of the contract.”
The profit taken in any year is calculated on a cumulative basis having regard to profit taken
in earlier years.
The appropriate part of the standard is:
“The amount to be reflected in the year’s profit and loss account will be the appropriate
proportion of this total profit by reference to the work done to date less any profit already
taken in previous year.”

The profit calculation is as follows:

If a loss is disclosed from the above calculation then this should be provided in full in the
period’s accounts.

If there is a projected profit disclosed this would be used in the following formula:
Profit to date = Cost of works completed ÷ Total estimated contract × Estimated contract profit.

The amount of profit to be recognized in the current period is calculated on cumulative

principles as follows:

(a) When the contract has just started:

In such case no profit should be taken into account, as it is impossible to see the future
position clearly. Generally, up to 1 /4th completion of the contract, this principle is followed.

(b) When the contract has sufficiently advanced:

(i.e. more than 1/4th of the contract is completed)

A reasonable portion of the notional profit (difference between value of work certified and
cost of work certified) should be credited to Profit & Loss A/c and the balance is carried
forward in the same contract as a profit in suspense as adequate reserve for future losses and
contingencies. The portion of notional profit to be taken will depend upon the progress of the
work.

Profit of Incomplete Contract:

(i) For completion less than 50% of contract – 1/3 × Notional Profit
(ii) For completion 50% or more of contract – 2/3 × Notional Profit
Where the cash received in respect of an incompleted contract is less than the value of the
work certified, the above proportion (i.e. ⅓ or ⅔ of profit should also be reduced in
accordance with the percentage of cash received to the value of work certified.
(c) When the contract is almost complete:
If the contract is nearly completed and only a small portion of the work remains to be done,
the cost of completing it should be estimated and added to the actual expenditure already
incurred thereon. The total estimated cost will then be deducted from the contract price to
calculate the estimated profit.
Sometimes the estimated total cost includes a further provision for contingencies. Thus, like
case (b), a portion of the estimated profit is to be credited to the Profit and Loss A/c,
remaining a portion for guard against unforeseen circumstances.

The profit may be taken by adopting any one of the following formulae:

Loss of Incomplete Contract:

If any contract suffers loss, that loss is to be charged to the Profit & Loss A/c. Again, if it is
expected that there may arise a further loss before the completion of the contract, necessary
provision should be made in the Profit & Loss A/c for such loss also.