CONTRACT COSTING

Contract costing is a method of costing applied to ascertain the cost of a work undertaken on a
contract basis. It is used by concerns engaged in building construction, plant erections, repair
and maintenance work, construction of bridges, road and railway line construction etc.

ICMA London defines contract costing as “that form of specific order costing which applies
where work is undertaken to customer's special requirements and each order is of long duration'.
Big job is called a contract and small contract is called a job. Hence, contract costing and job
costing closely resemble each other.

Contract costing is also known as terminal costing' because it relates to jobs undertaken for a
specific purpose and definitely terminable. The concern or the person executing the contract is
known as the 'Contractor’ and the party or the person for whom the work is executed is known as
‘Contractee’.

Features:
1. Contracts are jobs requiring longer period (may even require more than one accounting
period).
2. Generally, work is executed either at the premises of the contractee or at the contract site. It is
not at the premises of the contractor.
3. Each contract is treated as a separate cost unit for the purpose of cost determination and cost
control; Cost of each contract is ascertained separately. For this purpose, each contract is given a
number and a. separate account is opened for each contract.
4. Contracts are executed as per the specifications given by the contractee. Hence, each contract
may be dissimilar to the other.
5. Since the work is undertaken at the contract site, most of the items of cost chargeable to
contracts are direct in nature.
6. The consideration the contractee has to pay to the contractor for executing the contract is
known as contract price.
7. Contractee makes payment to the contractor in instalimentents depending on the extent of the
work already completed by the contractor and certified as complete by contractee's engineer

Distinctions between job costing and contract costing: Contract suppl

architect.

JOB COSTING CONTRACT COSTING

Job is small in size. Hence, it takes less time Contract is bigger in size. Hence, it takes
to complete. more time to complete

Job work is executed at the premises of . Contract work is executed outside the
the contractor the contractor (i.e. the manufacturer
The price of the job is paid in full after Generally the contract price is paid in
completing the job. installments depending upon the
progress of work.

Since number of jobs are executed Most of the expenses incurred in execution of
simultaneously in the factory, a number of the contract are direct in nature
indirect expenses have to be apportioned to
these jobs
Job price is decided on the basis of pricing Pricing is influenced often by specific clauses
policy of the manufacturer. of the contract( eg. Escalation clause, de
escalation clause, cost plus contract clause)

Costing procedure: The main objectives of contract costing are (i) to ascertain the total cost of
contract and (ii) to ascertain the profit or loss on the contract. For these purposes contractor
maintains a contract ledger in which a separate account is opened for each contract undertaken.
A serial number is given to each contract to distinguish it from other contracts. Contract accounts
prepared as per the principles of financial accounting i.e. double entry system.

Important terms in CONTRACT ACCOUNTING:

Certificate of work:

In case of small contracts, the contract price is given by the contractee on the completion of the
contract. But in large Contracts, the contractor receives money from time to time, based on
the progress of work. Contractee appoints the (surveyor) or the architect engineer to inspect the
progress of the work.(Surveyor or the architect engineer issues á certificate stating that so much
portion of the contract has been completed. The value stated in this certificate is called the value
of work certified.

Uncertified work

Uncertified work ( or work done but not certified) refers to i) that portion of work completed by
the contractor but not approved by the architect either because that it has not reached stipulated
stage or that it is defective, and ii) the work done since the last date of the last certification.

Uncertified work is valued at cost and credited to the Contract a/c and debited to Work in
progress a/c.

Retention Money

The contractee, normally does not pay the entire amount of work certified to the contractor. He
pays only the part or a certain percentage of the work certified. The balance amount of work
certified is retained by the contractee as a safeguard or security against any dishonest behavior of
the contractor is called as Retention Money.

The contractee will pay the retention money to the contractor only when the entire contract is
completed satisfactorily or defects found later are made good.

Retention Money= Work Certified- Cash Received.

Work in Progress:

It includes the cost of work certified and work uncertified. It appears as Asset in the Balance
sheet as follows:

Value of work certified - xx

Add: cost of work uncertified- xx

Less: reserve for unrealized profit xx

Less: cash received from contractee xx

xx

PROFIT ON CONTRACT

a) In case of contract started and completed within one accounting period:

The difference between the contract price and expenses debited to the contract account
represents the profits ( or loss) and it is transferred to PROFIT AND LOSS a/c
b) In case of incomplete contract
Notional profit= W-I-P - Cost of contract to date

 Contract just commenced

When WORK CERTIFIED is less than ¼ of the CONTRACT PRICE:
No Notional profit is transferred to P&L account, entire amount of notional
profit is treated as RESERVE
 When WORK CERTIFIED is ¼ or more, but less than ½ of the
CONTRACT PRICE:
Profit to be transferred to P&L a/c is
= Notional profit*1/3*Cash received
Work certified
  When WORK CERTIFIED is 1/2 or more of CONTRACT PRICE:
Profit to be transferred to Profit and loss a/c is
Notional Profit*2/3* cash received
Work certified
 Loss on incomplete contracts must be charged to profit and loss account of the
accounting year.
c) In case of contract almost complete
When the contract is nearing completion, total estimated profit is computed and a portion
of it is transferred to profit and loss account.
ESTIMATED TOTAL PROFIT= contract price- (cost of the contract to date+
estimated additional cost to be incurred to complete the contract).

The profit to be transferred to profit and loss account is ascertained by adopting any of
the following formula:
 Estimated total profit* work certified*% of cash received
Contract Price
 Estimated total profit* work certified
Contract Price
 Estimated total profit* cost to date
Estimated total cost

Types of Contract
Based on pricing methods contracts may be classified as follows:
(i) Fixed price contracts
(ii) Contracts with escalator clause
(iii) Cost plus contracts and
(iv) Target price Contracts.
Fixed price contracts:

This is the most popular type of contract. The price of the contract is fixed at the time of signing
the contract. Contractor has to estimate the cost of the contract in advance and fix up the contract
price? A serious limitation of this type of contract is that in case of increase in the cost of
executing the contract due to unforeseen increase in prices of inputs, the contractor has no right
to revise the contract price and be
compensated for extra cost incurred.

Contracts with escalation clause: (or escalator clause):

In a contract for execution of work, special terms and conditions called escalation clauses are
often included. They are incorporated to safeguard the interest of both the contractor and the
contractee against uncontrollable and unfavorable changes in the prices of materials, labor,
equipment etc. These clauses stipulate that the contract price may be revised from time to time in
accordance with changes in the prices of material, labor and other items. They cover fluctuations
in the prices until the completion of the contract.

The escalator clause gives an opportunity to the contractor to make upward adjustments in
contract price in accordance with changes in the prices of materials, labor, equipment etc. This
clause provides that in case of increase in the prices of inputs (beyond a certain percentage over
the prices prevailing at the time of signing the contract), the contractee has to bear the additional
costs and compensate the contractor for extra costs incurred by increasing in prices. In such
cases, the contractee should have power to investigate or audit the relevant invoices of materials
or payroll of laborers. There may be a provisions in the contract giving powers to the contractee
to investigate whether the contractor is incurring such expenses prudently at prevailing rates in
the market.

De-escalation clause: This clause provides for reduction in the contract price when prices fall. It
stipulates that in case of fall in the price of material or labour beyond the specified level, the
contractor has to allow a rebate to the contractee.
Cost plus contract:

Cost plus contract is a pricing method. Under this method, a price is fixed by adding a certain
percentage of profit. Cost plus contract is a contract between the contractor and the contractee by
which the price to be paid by the contractee to the contractor includes the actual cost of the
contract plus an agreed amount of profit.

Target Price Contract:

It provides targets for production and for expenditure. The production and costs are pre
determined and fixed in advance. Measures are taken to ensure that the actual performance in
production and expenditure would not exceed the fixed targets. In case the actual costs are below
the targets fixed, the contractor is entitled to a bonus which is proportionate to the savings thus
made in costs.

Format

CONTRACT ACCOUNT NO………..

PARTICULARS AMOUNT PARTICULARS AMOUNT

To cost of material consumed: By abnormal loss XX
Purchased directly x a) Loss of material
Issued from stores x b) Loss of plant
Issued from other dept x x By plant / material returned to
Less: i) materials returned x stores XX
ii) materials transferred x By bank:
add: carriage on materials x XX a)cost of material sold x
To labors/ wages xx b)cost of plant sold x XX
Add: o/s xx XX By material at site XX
To other expenses XX By plant at site xx
To overhead charges XX Less: depreciation xx XX
To depreciation on Plant XX By cost of contract to the date XX
(balancing figure)

XXX XXX
To cost of contract b/d XX By W-I-P
To Notional profit(Balancing Work certified xx
figure) Work uncertified xx XXX
P&L a/c xx XX
Reserve xx
XXX XXX
To WIP By Reserve XXX
To plant at site By outstanding wages XXX
To material at site