In this article we will discuss about:- 1. Meaning and Definition of Contract Costing 2. Features of Contract Costing 3. Procedure 4. Computation of Profit or Loss 5. Cost Plus Method 6. Important Matters to be taken into Considerations.
Contents:
- Meaning and Definition of Contract Costing
- Features of Contract Costing
- Contract Costing Procedure
- Computation of Profit or Loss on Contract
- Cost Plus Method of Contract
- Matters to be Taken into Considerations While Solving Problems of Contract
1. Meaning and Definition of Contract Costing
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Contract costing is a variant of job costing. Like job costing, contract costing is also a form of specific order costing. So, both job costing and contract costing are based on the same costing principles. In fact, a big order is termed as a contract and a small order as a job. Contract costing is also known as terminal costing as the preparation of Contract Account is terminated or closed after the completion of contract.
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Example of undertakings which adopt contract costing are builders, civil engineering contractors, road making or repairing concerns, dams and bridge constructional concerns. The person who undertakes the work to complete is known as ‘Contractor’ and the person who gets the work done through contractor is known as ‘Contractee’.
The Institute of Cost and Management Accountants (I.C.M.A.) 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.”
“Contract or terminal costing is the term applied to the system adopted by those businesses which carry out substancial building or constructional contracts.” —Walter W. Bigg
From the above definition, it is clear that contract costing is a form or type of specific order costing under which there is an attribution of costs to individual contracts.
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2. Features of Contract Costing:
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Contract costing has certain distinctive features. The important features of contract costing are:
(1) Contracts are generally of large size and, therefore, a contractor usually carries out a small number of contracts in the course of one year.
(2) A contract generally takes more than one year to complete.
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(3) Work on contract is carried out at the site of contracts and not in factory premises.
(4) Each contract undertaken is treated as a cost unit.
(5) Separate Contract Account is prepared for each contract in the books of contractor to ascertain profit or loss on each contract.
(6) Most of the materials are specially purchased for each contract. These will, therefore, be charged direct from the supplier’s invites. Any materials drawn from the store are charged to contract on the basis of material requisition notes.
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(7) Generally, all labourers are treated as direct labourers.
(8) Most expenses, such as, electricity, telephone, insurance, etc. are also direct in nature.
(9) Plant and equipment may be purchased for the contract or may be hired for the duration of the contract.
(10) Payments by the contractee are made at various stages of completion of the contract based on architect’s certificate for the completed stage. An amount known as retention money is withheld by the contractee as per agreed terms.
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(11) Penalties may be incurred (paid) by the contractor for failing to complete the work within the agreed period.
(12) Contract costing is less detailed and simpler than job costing.
(13) Each contract or work involved in contract costing is executed or done as per the specifications given by the contractee. So one contract may be dissimilar to another contract.
(14) Contract costing is concerned with the costing of construction work or repair work and not with the costing of any goods.
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(15) As the contract is undertaken at the contractee’s promises most of the items of cost chargeable to a contract are direct costs. Indirect costs are very few.
(16) As the contract or work is done at the contract site far away from the premises of the contractor, the problem of cost control is greater in the case of contract costing. There can be loss of materials and equipment, damage to plants and wastage of labour, posing problem of cost control.
(17) In the case of contract costing, work commences on receipt of order from the customer.
(18) In case of complete contract, there is the problem of determination of the amount of profit to be carried to current year’s Profit and Loss Account, and the amount of profit to be carried forward.
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(19) There is no heavy investment on assets initially in the case of contract costing.
3. Contract Costing Procedure
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The basic procedure for costing of contracts is as follows:
1. Contract Account:
Each contract is allotted a separate number and a separate account is opened for each contract.
2. Direct Costs:
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Most of the costs of a contract can be allocated direct to the contract. All such direct costs are debited to the Contract Account.
Direct costs for contract include:
(i) Direct cost of materials,
(ii) Direct labour and supervision,
(iii) Direct Expenses,
(iv) Depreciation of Plant and Machinery,
(v) Sub-contract costs, etc.
3. Indirect Costs:
Contract cost is also debited with overheads which tend to be small in relation to direct costs. Such costs are often absorbed on same arbitrary basis as a percentage on prime cost, or material or wages, etc. Overheads are normally restricted to head office and storage costs.
4. Transfer of Materials or Plant:
When materials, plant or other items are transferred from the contract, the Contract Account is credited by that amount.
5. Contract Price:
The Contract Account is also credited with the contract price. However, when a contract is not complete at the end of financial year, the Contract Account is credited with the value (cost) of work-in-progress as on that date. Work- in-progress includes value of work certified and the cost of work uncertified.
6. Profit or Loss Account:
The balance of Contract Account represents profit or loss which is transferred to Profit and Loss Account. However, when contract is not completed within the financial year, only the part of the profit arrived is taken into account and the remaining profit is kept as reserve to meet any contingent loss on the complete portion of the contract.
4. Computation of Profit or Loss on Contract:
There may be three situations in the computation of profit or loss on contracts.
They are:
(I) Profit on completed contracts,
(II) Profit on uncompleted contracts,
(III) Profit on likely to be completed contracts.
I. Profit on Completed Contracts:
If a contract is begun and completed in the same financial year, then, the entire profit or loss made on such a contract should be transferred to the Profit and Loss Account. If there is profit, the same should be credited to the Profit and Loss Account and debit should be given to Contract Account. On the other hand, if there is loss, the same should be debited to the Profit and Loss Account and credit being given to the Contract Account.
II. Profit on Uncompleted Contracts:
Contracts which are started and finished during the same financial year create no accounting problems. But in case of those contracts which take more than one year to complete, a problem arises whether profit on such contracts should be worked out only on the completion of the contract or at the end of each financial year on the partly completed work. If profit is computed only on the completion of the contract, profit will be high in the year of completion of the contract, where as in other years of working on contract, profit will be nil.
This would result not only distorted profit pattern but also higher tax liability because income-tax at higher rates may have to be paid. Therefore, when contracts extend beyond a year, it becomes necessary to take into account the profit earned or loss incurred oh the work performed during each year. This helps in avoiding distortion of the year-to-year profit trend of the business.
There are two aspects of the profit computation:
(1) Computation of notional profit or estimated profit, and
(2) Computation of the portion of such profit to be transferred to Profit and Loss Account.
The portion of the notional or estimated profit to be transferred to Profit and Loss Account depends upon the stage of completion of the contract. Prudence requires that the total notional profit should not be transferred to Profit and Loss Account but a portion of it should be withheld as a reserve to meet any unforeseen future expenses or contingencies.
Rules:
There are no hard and fast rules in this regard.
However, the following general rules may be followed in this context:
1. First Rule:
When work certified is less than 1/4 of the contract price, no profit is transferred to Profit and Loss Account. This is based on the principle that no profit should be taken into account unless the contract has reasonably advanced.
2. Second Rule:
When work certified is 1/4 or more but less than 1/2 of the contract price, then generally 1/3 of the profit is transferred to Profit and Loss Account. The balance amount is treated as reserve. Thus, profit to be transferred to Profit and Loss Account is computed by the following formula –
3. Third Rule:
When work certified is 1/2 (i.e. 50%) or more but less than 9/10 (i.e. 90%) of the contract price, then the profit to be transferred to Profit and Loss Account is computed by the following formula –
4. Fourth Rule:
When contract is near completion then the estimated profit should be calculated on the whole contract. The proportion of estimated profit to be transferred to Profit and Loss Account is computed by any one of the following formulas:
5. Fifth Rule – Loss on Uncompleted Contracts:
In the event of a loss on uncompleted contracts, this should be transferred in full to the Profit and Loss Account. Whatever be the stage of completion of the contract.
5. Cost Plus Method of Contract
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Cost plus method of contract is that where contract price is not settled between contractor and contractee, but it is agreed that contractor will be paid a fixed percentage of profit on the total cost incurred by contractor on and above the total cost of the work done. Such type of contract is entered into in war time or time of economic fluctuation or where contract is to be executed in urgency and it is difficult to quote the price of the contract.
Application of Cost Plus Method of Contract:
Although, this type of contract is commonly entered into in war time or in time of economic fluctuation.
But, in the following situations, it proves to be useful:
(i) Where the production work has to be completed urgently.
(ii) When it is difficult to estimate the cost of labour, material and other costs.
(iii) When plant and machinery have to be imported from foreign countries.
(iv) When the work to be done is of nature and estimation of cost is difficult for the contractor.
(v) If material, labour, machinery and expert is provided by the contractee and contractor is to do the work of contract only.
Advantages of the Cost Plus Method of Contract:
(A) Advantages to the Contractor:
(i) Free from losses.
(ii) Certainty of profits in case of increasing prices of labour and material.
(iii) In times of uncertainty execution of contract becomes possible.
(iv) Free from getting approval of tender price.
(v) In case of urgency of execution of a contract.
(vi) Availability of the services of experts, raw materials and labour.
(B) Advantages to the Contractee:
(i) Quick completion of work.
(ii) Quality work.
(iii) Easy to get the work done in emergency.
Disadvantages of Cost Plus Contract Method:
(i) Generally contract price is increased under this method.
(ii) Excessive increase in expenses, since contractor is not worried about increasing cost.
(iii) Uneconomic use of raw material and labour by contractor.
(iv) Limited income to the contractor.
(v) Monotonous in contractor.
Specimen of Incomplete Contract:
Note: (1) If the total of debit side of Contract Account exceeds the total of the credit side of Contract Account, the resultant will be loss, which will be transferred to P/L A/c and not to Work-in- progress A/c.
(2) If contract is near to completion, then profit will be calculated by adopting the following formula –
If the contract is not completed by the end of financial year, then the uncompleted work is recorded in Work-in-progress Account. Work-in-progress Account is prepared by debiting to this account, the account of work certified and work uncertified and crediting it with the profit in reserve i.e. the portion of the profit not transferred to the Profit and Loss Account. The difference between the debit and credit side is Work-in-progress, while showing it in Balance Sheet, all cash received on account of such uncompleted contracts is to be shown as a deduction.
6. Important Matters to be Taken
into Considerations While Solving Problems of Contract:
The following important matters must be taken into consideration while solving problems concerning contracts:
1. First of all, the students should see that what accounts have been asked to be prepared. It is only contract account or contract account along-with Work-in-progress Account and Contracts Account. It should be further seen that balance sheet has been instructed to be prepared or only work-in-progress account has been asked to be shown in Balance Sheet?
2. Look at the date of beginning the contract and preparation of contract account, so that it can be ensured that for how much duration the particular contract is being prepared.
3. Ensure whether the contract has been completed or is incomplete so far. In case of incomplete contract, determine how much proportion of completed contract bears to contract price. Is completed work less than 1/4 of contract price or is equal to 1/4 or more but less than 1/2 of contract price or is equal to 1/2 or more but less than 9/10 of contract price or is about to be completed. This information is required to decide how much of profit earned could be credited to Profit and Loss Account.
4. As regards depreciation read carefully whether the term ‘per annum’ (p.a.) has been used with the rate of depreciation. If yes, then look at the period for which the plant and machinery has been used on the contract. If the word ‘p.a.’ has been used, then depreciation shall be calculated proportionately to the period the plant was in use on contract. If the term ‘p.a.’ is not used, then depreciation shall be calculated for one year. In such a case, the period of use of plant and machinery on contract shall not be considered.
5. If the contract is in the stage of completion, then estimated profit will have to be ascertained.
6. If the amount of work certified is not given, it will have to be ascertained. It is ascertained on the basis of amount received from contractee as a fixed percentage of work certified.
7. The value of uncertified work is always shown at cost, not at contract price. All expenses incurred by the contractor on contract from the date of certification to the date of preparation of contract account will be added to get the amount of uncertified work.
8. If material consumed as well as material in hand or at site are given, we can find out material issued to contract account by adding these two figures. In other words –
Material Issued = Material consumed + Material in hand or at site
9. In case the contract price is not given in question, then 2/3 of notional profit should be credited to Profit and Loss A/c.