Contract costing

Contract Costing

Some firms such as builders, construction contractors, civil engineering firms, construction and mechanical engineering firms are engaged in construction works such as construction of buildings, bridges, roads and so on. A firmengaged in the construction works requires to know the total cost of the construction work done. The total costs of the work help to find out the profit earned from these works. The cost information about construction works helps to monitor and evaluate the performance of contract work and to determine the total contract cost. Such information is provided by a costing method known as contract costing.

Contract costing is the costing method applied to determine the cost of construction work performedas per a customer's specification. Contract costing is also called terminal costing as it terminates with the discharge of contract work. The construction work is undertaken at the site allotted by the client. The contract sites vary and are always outside the premises belonging to the clients. A separate code number is allotted to each site where a number of contract works are undertaken. A contract account is maintained for each contract work to record the contract costs under contract costing. Maintaining a contract account helps to find out the amount of profit earned during a particular period since financial books do not report it separately. Normally, a contract account is prepared at every year-end to determine the profit for the specified period.

Definition of Contract Costing

CIMA defines contract cost as the aggregated costs relative to a single contract designated a cost unit.

CIMA defines contract costing as that form of specific order costing which applies where work is undertaken to special requirements of customers and each order is of long term duration.

Types of Contract

The following are the types of contract.

1. Fisted price contract
2. Fisted price contract subject to Escalation Clause.
3. Cost plus contract.

There are three types of contract which are mentioned below:

a. Fixed price contract: the contract that is executed with the fixed price which is agreed by the contract and the contractee is called the fixed price contract. Under this contract, no modification is made in the agreed contract price irrespective of the changes in the price level of material and labour in feature. In such type of contract, the contractor is benefited when the price of material and labour decrease. In contrary to this, the contractee is benefited if the price of material and labour increase.

b. Fixed price contract with escalation and de-escalation clauses: escalation clause is a of agreement that that aims to reduce the risks that is causes due to the changes in the price of materials, labour and other services. Under this, the contract price is adjusted in accordance, with the changes in the price of material, labour and other services. The additional cost raised due to the increase in price is born by the contracted. Similarly, the contract price is reduced if the cost decreases below a certain percentage. It is called de-escalation or reverse clause. Escalation clause safe guides the interest of both the contractor and contractor against unfavorable price change in future. Such clause may also apply where material and labour utilization exceeds a particular limit. In this case, however, contractor will have to prove that excessive utilization is not because of decrease in efficiency. The contractor allows a rebate in the bills presented by him to the extent of the decrease in price.

c. Cost plus contract: the contract in which the contract price is determined by adding a certain percentage of profit on cost is known as cost plus contract. The cost plus contract is adopted to overcome with problem of fixing the contract price price caused due to nature of contract, duration of completion of  contract, uncertainly of material, change in the price level, new technology etc. this type of contract is mostly followed by the government for production of special articles not usually manufactured, urgent repairs of vehicles, roads bridge etc. under this types of contract, the contract starts the work and payment is made by the contracted gradually on the basis of the cost incurred in the work completed plus certain percentage of profit.

Features of Contract Costing

The following are the features of contract costing.

1. A contract is undertaken according to the specific requirements of customers.

2. Generally, the duration of a contract is long period.

3. The contract is undertaken only at the site of the customer.

4. Contract work mainly consists of construction activities.

5. The specific order costing principles are applied in contract costing.

6. The size of a contract is usually large or bigger than jobs.

7. It requires a long time to complete a contract.

8. Each contract is an independent one, quite distinct from another.

9. A distinctive number is assigned to each contract to differentiate the contract from one another.

10. A separate account is maintained and prepared for each contract to find out the profit earned from each contract separately.

11. If a contract is not completed at the end of the accounting period, only a portion of profit is transferred to profit and loss account on the basis of stage of completion of a contract.

12. There is no problem of under absorption and over absorption of overheads.

13. Every conceivable expenditure is charged to the concerned contract.

14. If the materials, plants and other inputs are transferred from one contract to another, the transfer may be affected by giving debit and credit to the respective contracts.

15. The proportion of indecent costs to total cost of a contract is very small.

16. A contractor may appoint a sub — contractor(s) for the execution of the work of the main contract.

17. The contractee i.e. the customer pays money only on the basis of the work certified by the architect, engineer or surveyor.

18. Escalation clause may be incorporated in the agreement of the contract. It so, the contractor is protected from any rises in the prices of materials, labour and other inputs.

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. Whenever the materials are purchased from the open market, the values of materials are debited in the concerned contract account.

Similarly, if materials are issued from stores, the concerned contract account is debited and the stores control account is credited. Sometimes, some materials may be stolen or destroyed by fire, the value of materials is credited in the concerned contract as stores account and the same is transferred to profit and loss 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. The details of information regarding wages are obtained from the records of time sheet and wages sheet. Equitable base method is usually adopted to apportion the wages of supervisors working on two or more contracts.

Likewise, the overheads are also apportioned on suitable basis. The accrued wages and outstanding expenses are calculated at the end of the accounting period and 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.

Preparation of a contract account

Under the contract costing, a separate account is opened for each contract so as to ascertain the position of profit or loss. Such account is called a contract account. All the expenses incurred in the contract like material, wages, direct expenses, plant and machinery etc. are debited whereas material returned, and material at end, plant at end, work in progress or contract price in case of completion of the contract etc. are credited in the contract account. The difference between the debit and credit represents the loss or profit. The profit earned under the completion of the contract is regarded as net profit or net loss in case of loss. The profit earned from the contract which is in progress or not completed is called notional profit. When loss takes place in such a situation, it is called net loss. It is because that a loss can never be notional, it is always real. The specimen of a contract account is presented below:

a. When contract is totally competed: some contracts are small and can be completed within a year. In such a case, total contract price is show on the credit side of the contract account as contracture's account. In this case, if credit is heavy then balancing figure on debit side is called profit and if the debit side is heavy, then the balance figure on credit side will be called a loss.

b. When contract is incomplete: large contract take number of years to completion. In this situation, amount of work certified and uncertified are found in the contract. Such amount of work certified and uncertified should be shown on the credit side of the contract account under the head work-in progress account.

1. Work certified: the value of work completed and certified by contractee's engineers and architchets is called work certified. As per provision of the contract, a fixed percentage of such work certified is paid by contractee to contractor. Some percentage of work certified is retained money. The work certified included the portion of notional profit therefore, if the cost of certified is lower than the work certified, the different amount is called motioned ,profit, if the amount  of cost of  work certified is higher than the work certified, the different will be loss.

2. Work uncertified: on the date of preparation of contract account, there may be some competed but uncertified work. The work of contract which is completed but not certified by the engineers is called work uncertified. It is always recorded at cost price and not on contract prices so as to avoid any profit element in it. The work uncertified never includes the portion of notional profit.

Treatment of materials in contract account
The procedures of recording materials in a contract account are as follows:

Treatment of plant in contract account

The machinery used for a contract is recorded in a contract account through two ways. They are

i. The cost of machinery and equipment to be used for a longer period or purchase for the contract is shown in the debit side of a contract account. The book value of the machinery and equipment is shown in credit side. The book value is calculated by deducting the depreciation from the cost of the machinery and equipment.

j. If the machinery and equipment is used for a short time in the contract, the amount of depreciation charged is only debited in the contract account. In such a situation, the purchase price in the debited side and the book value in the credit side are not shown. This is generally done, if the plant and equipment are not used till the end of te accounting period.

The treatments of plant and machinery in a contract account under different conditions have been presented below:

Methods of transferring profit
The profit earned against the completion of a contract is assumed to be the net profit and transferred to profit and loss account. Generally, a contract is completed in a long-period of time and the profit/loss is to be calculated at the end of each accounting period. Out of the national profit i.e. the profit earned during the work in progress, only some portion is to be transferred to profit and loss account. The during the work in progress, only some portion is to be transferred to profit and loss account. The remaining part of the notional profit is transferred to reserve. Therefore reason. There are some factors which are to be considered to transfer the proportion of notional profit to profit and loss account and reserved. They are:
a. Work certified: the work of a contract completed by a contractor is supervised and certified by the engineer of the contractee. The portion of the work completed and certified by the contractee is called the work certified. The work completed but not certified due to different treasons is called the work uncertified. Work certified is one of the bases of transferring the national profit to the profit and loss account.
b. Cash received: the contractor received cash from the contracted depending on the level of work completed. He/she received cash on the basis of work certified. The whole amount of work certified is not paid to the contractor. The portion of work certified that is not paid to the contractor is known as retention money. The relationship between the work certified and cash receipts is shown below:
Cash received (Rs.) = work certified x % of cash received
% of cash received = 100% - Retention rate
Wok certified = cash received (Rs.) x 100/ % cash received
The ways of transferring notional profit and loss account are given below:
a. Transfer of profit of incomplete contracts

The methods of transferring the motioned profit when is in profess are given below:

b. Transfer of profit if contracts are almost completed

The contact in which it is possible to estimate the of contract completion and feature cost to be incurred to completed the work and more than 90% of the work has been completed is called the almost completed contract. The methods of ascertainment of profit and transferring the profit and loss account are given below:

Some other items used in costing account

a. Labour cost: all the workers engaged at the site of a particular contract, irrespective of the nature of the work performed by items, are treated as direct workers and the amount of wages paid to them as direct wages. Such wages are to be charged to the particular contract directly. In case a worker (generally the supervisory staff) is engaged at two or more contracts, his total wages may be apportionment to different contract on the basis of time devoted to each contract or on some other equipment basis' wages accrued or outstanding at the end of the accounting period should appear on the debit side of the contract account.

b. Direct expenses: all expenses (other than material cost and direct wages) 

which have been incurred specifically for a particular contract are direct expenses and shall be debited to contract a/c. example of direct expenses are: here charges of special plant (not owned), carriage on materials purchase, travelling expenses relating to contract, etc.

c. Indirect expenses: there are certain expenses, which cannot be directly charged to a particular contract e.g., salary of general manager, salary of architect engaged at a number of contract simultaneously, salary of storekeeper, expenses of store and office expenses. Since these expenses are incurred for the business as a whole, they are to be apportioned to the different contract on some equitable basis.

d. Cost of sub-contracts: generally, the work of a specialized character e.g., road construction in a building, installation of lifts, electrical fittings, is passed on to some other contractor by the main contractor. In such cases, the work performed by the sub-contractor forms a direct charged to be contractor concerned and the sub-contractor price paid shall be debited to contract account.

e. Cost of extra work: sometimes, in case of a contract, some additional work o variations of the work originally contracted for may be required by the contractee. Since the additional work required will not be covered by the terms and condition of original contract, it will be the subject of a separate charge., if the additional work required by the contractee is quite substation, it should be treated as a separate contract and dealt with in a separate account to be opened for it. But in case the additional work is not substantial, the expenses incurred on extra work should be debited to contract account as 'cost of extra work' and the extra amount which the contractee has agreed to pay to the contractor should be added to the original contract price.

f. Contract price: the contract price is the agreed price at which the contractor undertakes to execute to contractor. The contractor account is credited with the contractor price if it has been completed. In such a case, the amount of contract price is debited to the 'contractee's personal account and credited to the 'contract account'. No entry is passed in respect of the contract price in case of incomplete contracts.

g. Retention money: generally, the terms of the contract provide that the whole of the amount shown by the archive's certificate shall not be paid to the contractor but a specified percentage or portion money (say 10% or 20%) thereof shall be retained by the contractee till the contract.  Te money so retained is known as 'Retention money'. The cash received from the contractee is credited to his personal account. The value of work (certified and uncertified) is debited to work-in progress account. The work-in-progress account is shown as an asset in the balance sheet after deducting the amount received from the contractee. In the beginning of the next year the work-in-progress account is transferred to the debit side of the contract account. On competition of the contract, the contractee's account is debited and contract account is credited by total contract price.

Differences between job order and contract costing

The differences between job order contacts costing are mentioned below:

Similarities between job order and contract costing
The similarities between job order and contact costing are mentioned below:
• Both jobs and contracts are based on the specific requirements of customers. As a result, each job or contract is 'tailor-made' and there is no exact repetition of a job or contract.
• Both job and contract is terminal. Each job and contract can be identified from start to finish and, therefore, costs can be identified for each job a contract.
• The basic principles of contract costing are similar to those applied in job costing