Chapter 10:

Contract costing
SPECIFIC OUTCOME
After studying this chapter, the learner should be able to achieve the
following specific outcome:
• Administer contract accounts.
ASSESSMENT CRITERIA
Learners will demonstrate that they have achieved the specific
outcome when they can do the following:
• Prepare contract accounts including extra work and certified work.
• Determine the profit or loss on a contract.
10.1 INTRODUCTION
10.2 DIFFERENCES BETWEEN
CONTRACT COSTING
AND JOB ORDER
COSTING
• In contract costing the main work is done on site while with job
order costing the job is done at the contractee’s work place
• In job order costing profit is recognised on the day of delivery,
while in contract costing due to the duration of the contract,
revenue is recognised based on stages of completion
10.3 CHARACTERISTICS OF
CONTRACT COSTING
• There is a higher proportion than usual of direct costs. Items
normally classified as indirect costs can be identified specifically
with a particular contract. For example: the telephone costs of the
site office can be charged directly to the specific contract.
• There are low indirect costs. The only indirect cost is often head
office charges which are charged to the different contracts, usually
on a percentage basis.
 CHARACTERISTICS OF CONTRACT COSTING

• It is difficult to control costs. Sometimes the site is in a remote

area, as in the construction of a bridge or dam and it becomes
difficult to control material usage, damage to plant, loss of tools
etc.
• There are often surplus materials on completion of the contract.
– If the material is returned to the storeroom the contract account
is credited and the material control account debited
– If the material is directly transferred to another contract, the
old contract account is credited and the new contract account is
debited
10.4 CONTRACT PRICING

Fixed price contract

• Price is inclusive of all necessary steps to finish the job
• Disadvantage is that if costs escalate, quality of work might be
compromised
 CONTRACT PRICING

Cost plus contract price

• Unforeseen circumstances may arise
• Led to the inclusion of a cost escalation clause
• This stipulates the adjustment of the contract price if there is a
change in material price or labour payments
10.5 SPECIFIC CONTRACT
COSTING
TERMINOLOGY

Contract price
• Price for the work done by the contractor per stage of work
completed
• Contract costing can take place over several accounting periods
• Contractor will therefore claim certain payments for work
successfully completed
 SPECIFIC CONTRACT COSTING TERMINOLOGY

Certified work
• Progress payments are made during the course of the contract
• This is done according to certificates that are issued by the client’s
supervising architect, quantity surveyor or engineer at specific
stages of the work
• A certificate specifies the contract value of the approved work
completed up to the date of the certificate
• The basic formula to calculate percentage of completion is:
Cost incurred to date ÷ Total contract cost
 SPECIFIC CONTRACT COSTING TERMINOLOGY

Retention money
• It is usual for clients to withhold a certain percentage of each
progress payment, in order to protect themselves against defective
work by contractors
• Usually provided for, in the agreement between client and
contractor
• Held for a specified period after the completion of the
contract/until all retention work has been carried out to the
satisfaction of the supervising architect
 SPECIFIC CONTRACT COSTING TERMINOLOGY

Uncertified work
• Determination of the work done for which the architect issues his
certificate is done at times to which the parties agree
• It is not necessarily done on the last day of the contractor’s
accounting period, and there will usually be a portion of the
contract that has progressed since the issuing of the last certificate
• Costs of uncertified work must be determined at the end of the
accounting period
• It is shown as work in process as an asset in the statement of
financial position
 SPECIFIC CONTRACT COSTING TERMINOLOGY

Material on site
• There is usually unused material, ordered specifically for the
contract on hand, at the end of the accounting period
• Unused material is:
– valued at cost price
– carried over to the next period
– shown as an asset in the statement of financial position
 SPECIFIC CONTRACT COSTING TERMINOLOGY

Extra work
• It often happens that the client requests the building contractor to
do extra work after the contract price has been agreed upon. For
example, a client requests the contractor to fit additional cupboards
in the house he is building for the client
• This extra work will increase the contractor’s total selling price,
but it will also result in additional contract costs
 SPECIFIC CONTRACT COSTING TERMINOLOGY

Reserve (provision) for contingencies

• All the profit should not be taken into account when a contract is
incomplete at the end of a financial period
• The contractor should estimate the profit conservatively to allow
for possible defect for which he or she could be liable in future
• This allowance for possible future defects should be transferred to
an account known as reserve for contingencies
 SPECIFIC CONTRACT COSTING TERMINOLOGY

Notional profits
• Contract works performed are usually for a period longer than
accounting periods
• If the contractors wait for the day of payment to determine profit
or losses, the profit will look depleted
• It is therefore standard practice in accounting to pay them a certain
amount of the contract price so they can determine their profit or
losses according to the stage of the work completed
10.6 CONTRACT COST
ELEMENTS


 CONTRACT COST ELEMENTS

Contract costs
Direct contract costs
• Costs incurred for a specific project
• They may be reduced by incidental income, for example income
from the sale of surplus materials and the disposal of plant and
equipment at the end of the contract
 CONTRACT COST ELEMENTS
Contract costs

Examples of Direct contract costs

• Material purchased directly for a project and material charged
from a central store to a specific project
• Site or project wages including supervision
• Sub-contractor work
• Costs of hiring plant and equipment for the particular contract
• Costs of moving plant and equipment to and from the contract site
• Depreciation of plant and equipment used on the contract
• Costs of design and technical assistance directly related to the
contract
• Financing costs where funds are borrowed specifically for a
particular project
 CONTRACT COST ELEMENTS
Contract costs

Indirect contract costs

• Relates to general project activities that are allocated to individual
projects

Examples of indirect contract costs

• Warehouse cost
• General insurance
• Transport
• Cost of design and technical assistance that are not directly related
to a specific contract
• Construction overheads that include the preparation and
processing of construction staff payroll
 CONTRACT COST ELEMENTS

General costs
• Cost incurred in order for the enterprise to function
• Cannot be allocated to a specific contract
• Apportioned to the various contracts

Examples of General costs

• General administrative costs
• Head office costs
• Selling costs
• Financing costs other than for particular projects
• Research and development costs
• Depreciation of idle plant and equipment not used on a particular
contract
10.7 COMPLETED
CONTRACTS
• A separate ledger account is kept for each contract
• The general objective is to establish the overall contract profit of
loss
• The contract account is divided into two sections
– The first section determines the costs that should be included in
the cost of sales for the purpose of calculating the profit (or
loss) on the contract. The balance represents the cost of sales
(cost of work certified) attributable to the contract
– The second section of the contract account is the “Trading
account” section. In this section, the final profit (or loss) will
be determined
 COMPLETED CONTRACTS

Debit entries Credit entries

Direct costs (material, labour) Plant, materials transferred
Direct expenses (plant hire, out
sub-contractors, architects’ Final contract value (if
fees, etc.) completed)
Cost of plant bought Sales value of completed
Plant, materials transferred in work (if contract is
incomplete)
Head office charges
Final profit

See Example 10.1 (Textbook page 227)

 Question 10.1
Hochveld Limited completed contract 770 by the end of its accounting period, at 29
February 20X8. Details regarding this contract are as follows:
R
Material issued from store to contract site 100 000
Machinery purchased and delivered at site 25 000
Lease of equipment 12 000
Wages paid 31 000
Material returned from site to main store 10 000
Machinery transferred to contract 777 on completion 19 000
Work certified by architect 215 000
Extra work certified by architect 23 000
Architect’s fees paid 14 000
Overheads absorbed 16 500
Head office costs 9 700

The client was satisfied with the work done by Hochveld Limited and paid for all the work
certified by architect.

REQUIRED:
Show the contract account in the ledger of Hochveld Limited.
Chapter 10:
Contract costing
10.8 INCOMPLETE
CONTRACTS
• If a contract is incomplete at the end of the accounting period, a
profit may only be taken if the contract is in a reasonable state of
completion
• The contract account will show a balance in the account for
machinery, tools and material that are still on the site and work
completed but for which and architect’s certificate has not yet been
issued
 INCOMPLETE CONTRACTS

• This balance will appear in the balance sheet under “Inventory” as

“work in process”
• Accrued and prepaid amounts must be taken into account when the
profit is computed
See Example 10.2 (Textbook page 229)

See Example 10.3 (Textbook page 231)

See Example 10.4 (Textbook page 234)

 Question 10.3
The data given below relate to Contract 179 which deals with the
construction of a filtration plant for a chemical company. The contract
started on 1 April 20X3 at an agreed price of R20 000 000. It was expected
to take four years to complete. Retention money was agreed at 10% of the
value of work certified. Details of the contract during the first year are as
follows:
Transactions during the year R’000
Direct materials: Received at site 2 560
Returned from site 25
Lost from site (but insured) 30
At site at 29 February 20X4 355
Direct wages: Paid 1 320
Accrued at 29 February 20X4 30
Direct expenses: Paid 240
Accrued at 29 February 20X4 10
 Question 10.3 (Cont.….)

Plant: Assigned to contract, at cost 2 000

Valuation at 29 February 20X4 1 500
Site overheads 370
Head office charges 180
Cash received in respect of work certified 4 500
Cost of work completed but not yet certified 700

The amount owing by the debtor at the end of the first year was only the
retention amount allowed in terms of the contract.

REQUIRED:
a) Prepare the ledger account for the contract for the year ending 29
February 20X4.
b) Show the relavant statement of financial position entries for the
contract at 29 February 20X4.
10.9 GUIDELINES FOR
CALCULATING INTERIM
PROFITS
FORMULA
Interim profit = Sales value of certified work – Cost of certified
work (Cost of sales)

• When a contract is still in progress at the end of the accounting

period, it is necessary to estimate the profit earned in the
accounting period
 GUIDELINES FOR CALCULATING INTERIM PROFITS
FORMULA

• Because there is an element of risk and uncertainty with an

incomplete contract, the attributable profit in any period should be
conservatively estimated to allow for unforeseen difficulties and
costs
• The amount held back for possible defects for which the contractor
could be liable, is transferred to a reserve for contingencies
• However, if a contract shows a loss, the full amount of the loss
should be transferred to the profit and loss account
• Profit should reflect the degree of completion
• If the contract is at an early stage (say, less than 30% complete),
no profit should be taken.

Concept of prudence: whereas profits may be underestimated, losses

may never be underestimated
 GUIDELINES FOR CALCULATING INTERIM PROFITS

Options for estimating interim profit

We are going to look at two different methods for two sets of
circumstances, namely when substantial costs have been incurred,
and when the contract is nearing completion
 GUIDELINES FOR CALCULATING INTERIM PROFITS
Options for estimating interim profit

Substantial costs incurred means that:

• The contract is 30% to 80% complete
• It is reasonably certain that a profit will be earned
• It is also called the work certified method

FORMULA

Notional profit = Value of work certified – Cost of work certified

 GUIDELINES FOR CALCULATING INTERIM PROFITS
Options for estimating interim profit

Contract nearing completion

• Over 80% complete
• Eventual profit can be assessed with reasonable certainty
• No need for excessive prudence
• It is also called the percentage of completion method

FORMULA

Estimated total profit = Contract price – (actual cost to date +

estimated cost to complete)
See Example 10.5 (Textbook page 237)

See Example 10.6 (Textbook page 238)

See Example 10.7 (Textbook page 240)

 Question 10.6
Mulilo Limited have supplied the following data concerning one of its
contracts:

Contract price R200 000

Cost incurred to date R115 000
Estimated cost to complete the contract R37 000
Value of work certified by architect R120 000
Progress payments received from client R100 000
Cost of work certified R84 000

REQUIRED:
Calculate what amount of profit should be taken on the contract, using each
of the following two methods:

a) The work certified method

b) The percentage of completion method
10.10 SUMMARY