Semester: II

COST & MANAGEMENT ACCOUNTING-I

Dr. Rama Nag De
Associate Professor
CONTRACT COSTING

Introduction
Contract costing, also known as terminal costing, is a variant of job costing.
Contract means a big job in which work is done at site and not in factory
premises. The cost of each contract is ascertained. Thus, in this method of
costing, each contract is a cost unit and an account is opened for each
contract in the books of contractor to ascertain profit/loss thereon.
Features of Contract Costing
Contract costing usually shows the following features:
1. Contracts are generally of large size and, therefore, a contractor usually carries out a
small number of contracts at a particular point of time.
2. A contract generally takes more than one year to complete,
3. Work on contracts is carried out at the site of contracts and not in factory
premises.
4. Each contract undertaken is treated as a cost unit.
5. A separate contract account is prepared for each contract in the books of contractor to
ascertain profit or loss on each contract.
6. Nearly all labour cost will be direct.

7. Most expenses (e.g., electricity, telephone, insurance, etc.) are also direct.
8. Specialist subcontractors may be employed for say, electrical fittings, welding work,
glass work, etc.
9. Plant and equipment may be purchased for the contract or may be hired for the duration
of the contract.

Contract Costing and Job Costing — Distinction

Main points of distinction between contract costing and job costing are as follows:
1. Contract is generally big while job is small. It is well said, “a job is a small contract and
a contract is a big job.”
2. The number of jobs undertaken at a time are usually large as compared to number of
contracts because contracts are generally much bigger in size.
3. In contract costing most of the costs are chargeable direct to contract accounts. Under
job costing, direct allocation to such an extent is not possible.
4. Allocation and apportionment of overhead costs is simpler in contract costing as
compared to job costing.
5. Jobs are usually carried out in factory premises while contract work is done at site.

Contract Costing Procedure

The basic procedure for costing of contracts is as follows:
1. Contract account. Each contract is allotted a distinct number and a separate account
is opened for each contract.
2. Direct costs. 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 contracts include:
 (i) Materials, (ii) Labour and supervision, (iii) Direct expenses, (iv) Depreciation of plant and
machinery, (v) Subcontract costs, etc.
3. Indirect costs. Contract account is also debited with overheads which tend to be small
in relation to direct costs. Such costs are often absorbed on some arbitrary basis as a percentage
on prime cost, or materials, 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 the financial year, the contract account is credited
with the value of work-in-progress as on that date
6. Profit or loss on contract. 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 a part of the profit arrived is taken into account and the remaining profit is
kept as reserve to meet any contingent loss on the incomplete portion of the contract. This is
discussed in detail later in this chapter.

SPECIAL POINTS IN CONTRACT COSTING

Some of the important points in contract costing are now discussed:

Cost of Materials
Materials include (i) materials specifically purchased for the contract; (ii) materials issued
from store against material requisition notes. The cost of both these types of materials is debited
to the contract account.
Materials returned to store. Whenever materials are issued in excess of requirements, as
for instance, cement, sand, pipes, bricks, etc., these are later returned to the store accompanied
by a Material Return Note which gives the details of the material returned. Such returned
materials are credited to contract account.
Materials at site. At the end of each accounting period, value of materials lying unused
at site is credited to contract account and is carried forward for charging against the next
period.

Cost of Labour
All wages of workers engaged on a particular contract are charged direct to the contract
irrespective of the type of work they perform. When several contracts are running at different
locations, payroll is normally sectionalised so as to have separate payroll for each contract.
Difficulties in costing may be encountered when some workers may have to move from one
site to another when a number of small contracts are undertaken. In such situation, it becomes
necessary to provide time sheets from which allocations can be made. In order to control labour
utilisation and prevent fraud in the payment of wages, surprise visits by head office personnel
will be necessary.
Plant Depreciation
There are two different methods of dealing with depreciation of plant in contract account:
(a) Contract account is debited with the cost of the plant installed. At the end of the year
or when the plant is no longer required, the plant is revalued and contract account is credited
with this revalued or depreciated figure. In case plant is sold on the completion of the contract,
the contract account is credited with its sale proceeds. The net effect of the above debit and
credit will be that the contract account will stand debited with the amount of depreciation which
is the difference between the value of plant debited and value of plant credited. The method is
generally used on long contracts which extend over more than one year because depreciated
value of the plant is credited to the contract account and brought down as an opening balance
in the next period.
(b) Alternatively, contract account is simply debited with the amount of depreciation. It is
usual to use this method when plant is sent to contract only for a short period. For example,
mobile crane or bulldozer used in a contract may be charged on this basis.
However, when a plant is hired for a contract, a charge for the hire of the plant is debited
to the contract as a direct expense.
Subcontract Costs
Work of specialised character, for which facilities are not internally available, is offered
to a subcontractor. For example, steel work, glass work, painting, etc., is usually carried out by
the subcontractors who are accountable to the main contractor. The cost of such work is charged
to the contract account.

Payment based on Architect’s Certificate

In case the contract is small, full payment is usually made on the completion of the
contract. But in case of large contracts, it may take more than one year to complete. In such a
case, if no payment is received until the completion of the contract, the financial resources of
the contractor could surely become strained. Therefore, a system of progress payments is agreed
by parties. In this system, part payments of the contract amount are paid from time to time on
the basis of certificate issued by the architects (acting for the contractee), certifying the value
of the work satisfactorily completed. Such payments received by the contractor are usually
credited to the personal account of the contractee. It should be noted that such payments are not
entered in the Contract Account.

Work-in-progress — Work Certified and Uncertified

When the contract is not completed till the end of the accounting year, the architect is
required to value the work-in-progress. Such work-in-progress is classified into work certified
and work uncertified.
Work Certified. This is that part of the work-in-progress which has been approved by the
contractee’s architect or engineer for payment. Work certified is valued at contract price (i.e ,
selling price), and includes an element of profit.
Work Uncertified. This is that part of the work-in-progress which is not approved by the
architect or engineer. This is valued at cost and thus does not include an element of profit.
Both work certified and uncertified appear on the credit side of the contract account and
also on the assets side of the balance sheet.
Retention Money and Cash Ratio
It is usual practice not to pay the full amount of work certified. The contractee may
pay a fixed percentage, say 80% or 90% of the work certified, depending upon the terms of the
contract. This is known as Cash Ratio. The balance amount not paid is known as Retention
Money. For example, if cash ratio is 75%, the retention money will be remaining 25%. This
retention money is a type of security for any defective work which may be found in the contract
later on. This also works as a deterrent for the contractor to leave the contract incomplete,
if he finds the contract unprofitable. The retention money may also be adjusted against penalties
that become due if the contract is not completed within the stipulated time as per the terms of
the agreement.

Extra Work
Sometimes the contractor is required to do some extra work like additions or alterations
in the work originally done as per agreement. The contractor will charge extra money for such
extra work. The cost of such extra work is debited to the contract account and extra price
realised is credited to the contract account.

PROFIT ON INCOMPLETE 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, whereas in other years of working on contract, profit will be nil. This would result not
only in 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) on 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 profit computation:
 (a) Computation of notional profit or estimated profit.
(b) Computation of the portion of such profit to be transferred to Profit and Loss Account.

Notional Profit
Notional profit is the difference between the value of work-in-progress certified and the
cost of such work-in-progress certified. It is computed as follows (Figures are assumed):
`
Value of work certified 20,00,000
Add: Cost of work not yet certified 1,50,000
21,50,000
Less: Cost of work to date 19,00,000
Notional Profit 2,50,000
If in any year, cost of work done exceeds the value of work certified and uncertified, the
result will be a notional loss.

Estimated Profit
Estimated profit represents the excess of the contract price over the estimated total cost of
the contract. It is computed as follows (Figures are assumed):
`
Contract Price 30,00,000
Less: Total cost already incurred 21,00,000
9,00,000
Less: Estimated additional costs to complete the contract 3,50,000
Estimated Profit 5,50,000

Portion of Notional Profit or Estimated profit to be Transferred to Profit

and Loss Account
The portion of the notional or estimated profit to be transferred to P&L Account depends
upon the stage of completion of the contract i.e., ratio of work-in-progress certified to total
contract work. For this purpose work-in-progress uncertified is not considered. Prudence
requires that the total notional profit should not be transferred to P&L 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 :
1. When work-in-progress 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. When work-in-progress 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:
Transfer to P&L A/c = Notional profit × 1/3
Alternatively, a more common practice is to further reduce this amount by the cash ratio.
Cash received
Transfer to P&L A/c = Notional profit × 1/3 ×
Work certified

3. When work certified is 1/2 or more but less than 9/10 of the contract price, (i.e., 50% to
90%), then the profit to be transferred to P & L Account is computed as follows:

Transfer to P&L A/c = Notional profit ×2/3

Here also a more common practice is to further reduce this amount by cash ratio. This is
shown below:

Transfer to P&L A/c = Notional profit × 2/3 × Cash received

Work certified
 4. 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:
Work certified
(a) Estimated profit ×
Contract price

Work certified Cash received

(b) Estimated profit × Contract price ×
Work certified

Cost of work to date

(c) Estimated profit × Estimated total cost of work

Cost of work to date Cash received

(d)
Estimated profit × Estimated total cost of work ×
Work certified
 5. 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.

ESCALATION CLAUSE
Contracts generally take long time to complete and in this period there may be changes in
prices. Escalation clause is often provided in contracts to cover any likely changes in the
price or utilisation of materials and labour. Thus, a contractor is entitled to suitably enchance
the contract price if the cost rises beyond a given percentage. The object of this clause is to
safeguard the interest of the contractor against unfavourable changes in cost. The escalation
clause is of particular importance where prices of material and labour are anticipated to
increase or where quantity of material and/or labour time cannot be accurately estimated.
Just as an escalation clause safeguards the interest of the contractor by upward revision
of the contract price, a de-escalation clause may be inserted to look after the interest of the
contractee by providing to downward revision of the contract price in the event of cost going
down beyond an agreed level.

COST-PLUS CONTRACTS
Cost-plus contract is a contract in which the contract price is ascertained by adding a
specified amount or percentage of profit to the costs allowed in the contract. This type of
contract terms are agreed upon in those cases where it is not possible to compute the cost in
advance with a reasonable degree of accuracy due to unstable conditions of market prices,
labour rates, etc. The contractee undertakes to reimburse the actual cost of contract plus a
stipulated profit. The profit to be added to cost may be either a fixed amount or a specified
percentage of cost. The items of cost to be included for the purpose of determining contract
price are broadly agreed upon in advance. The accounts of the contractor are usually subject to
audit by the contractee.
Cost-plus contracts are usually entered into for executing special type of work, like
construction of dam, powerhouse, newly-designed ship, etc., where cost estimation is difficult.
Government often prefers to give contracts on ‘cost-plus’ terms.
Cost-plus contracts offer the following advantages:
To the Contractor:
1. There is no risk of loss on such contracts.
2. It protects him from the risk of fluctuations in market prices of material, labour,
etc.
3. It simplifies the work of preparing tenders and quotations.
To the Contractee:
The contractee can ensure a fair price of the contract by being entitled to audit the accounts
of the contractor.
The disadvantages of cost-plus contracts are:
To the Contractor:
1. The contractor is deprived of the advantages which would have accrued due to
favourable market prices.
2. The contractor has to suffer for his own efficiency. This is because profit is usually
based as a percentage of cost and efficient working resulting in lower cost also leads
to lower profits.

To the Contractee:
1. The contractee has to pay more for the inefficiency of the contractor as a contractor
 has no incentive to reduce costs.
2. The price a contractee has to pay is unknown until after the completion of work.

Problem 1
The BBA Construction Company undertakes large contracts. The following
particulars relate to contract No. 125 carried out during the year ended on 31st March,
2015.

Particulars Rs. Particulars Rs.

Work certified by architect 1,43,000 Wages accrued on 31st March 1,800
Cost of work not certified 3,400 2,400
Plant installed at site 11,300 2015 Direct expenditure 1,400
Value of plant on 31st March 8,200 Materials on hand on 31st March 400
2015 2015 Materials returned to store
Materials sent to site 64,500
Direct expenditure
Labour 54,800 200
Establishment charge 3,250 accrued on 31st 2,00,000
March 2015 1,30,000
Contract price
Cash received from contractee

Prepare a Contract Account for the period ending 31st March 2015 and find out the profit.
It was decided to transfer 2/3 of the profit on cash basis to Profit and Loss Account.
Solution:

Contract No. 125 Account for the year ending 31st March, 2015

Particulars ` Particulars `

To Materials sent to site 64,500 By Materials returned 400

To Labour 54,800 By Materials in hand By 1,400
To Establishment charge 3,250 Work-in-Progress:
To Direct expenses 2,400 Certified 1,43,000
To Wages accrued 1,800 Uncertified 3,400
To Direct expenses accrued 200 By Plant at site 8,200
To Plant at site 11,300
To Notional Profit c/d 18,150

1,56,400 1,56,400

11,000 By Notional Profit b/d

To P&L A/c 18,150
(18,150 x 2/3 ) x (1,30,000/ 1,43.000)

To Reserve 7,150

18,150
18,150

Problem 2
Simplex Construction Ltd. agreed to take a contract for construction of a bridge on 01.07.2017.
The contract price was Rs. 5,00,000. The company incurred following expenses up to
31.12.2017:
Particulars Rs.
Materials consumed 1,10,000
Wages 40,000
Direct expenses 20,000
Plant purchased on 01.07.2017 1,00,000
Materials in hand on 31.12.2017 5,000
Additional information:
 Depreciation on plant @10% per annum.
 Charge other works expenses @20% of wages & office expenses @10% of works cost.
 The amount certified by the contractee’s engineer was Rs. 3,00,000, retention money
being 20% of the certified value.
Prepare Contract A/c showing the amount of profit that the company can reasonably take to
its P/L A/c.
SOLUTION:
Simplex Construction Ltd.
Dr. Contract No. 126 Account for the year ending 31st March, 2015 Cr.
Particulars Rs. Particulars Rs.
31.12.17 31.12.17
To materials consumed 1,10,000 By Work-in-progress c/d 3,00,000
To wages 40,000 (value of work certified)
To direct expenses 20,000
To depreciation on plant 5,000
(6 months)
To other works expenses 8,000
(20% on wages)
Works Cost 1,83,000
To office expenses (10%
18,300
on works cost)
2,01,300

To Profit & Loss A/c 52,640

(profit transferred) (WN:1)
To Work-in-progress c/d
(provision) 46,060
3,00,000 3,00,000
01.01.2018

To Work-in-progress b/d:
Value of certified work 3,00,000
Less: Provision 46,060
2,53,940
Working Notes
1. Proportion of profit to be transferred to Profit & Loss A/c:
 Accounting profit: Rs. (3,00,000-2,01,300) = Rs. 98,700
 Profit on realized basis: 80% of Rs. 98,700 = Rs. 78,960
 Proportion to be transferred to P/L A/c: 2/3 of Rs. 78,960 = Rs. 52,640

PROBLEM 3
S Ltd. furnished the following information in respect of incomplete contract as on 31.3.2016.
 Particulars Contract A (Rs.) Contract B (Rs.)
Contract Price 2,40,000 1,50,000
Work certified 2,16,000 1,00,000
Estimated cost of completion of contract 2,10,000 1,20,000
Cash received 1,16,000 80,000
Uncertified Work 10,000 7,000
Cost of contract (expenditure incurred up to 31.3.16) 1,80,000 95,000
Calculate the profit to be carried to P/L A/c for the year ended 31.3.16.
SOLUTION:
P Ltd.
Dr. Contract No. 127 Account for the year ending 31st March, 2015 Cr.
PARTICULARS A B PARTICULARS A B
To cost of contract 1,80,000 95,000 By works certified 2,16,000 1,00,000
To accounting 46,000 12,000 By works 10,000 7,000
profit c/d uncertified
2,26,000 1,07,000 2,26,000 1,07,000

To P/L A/c (WN: 1) 22,716 6,400 By accounting 46,000 12,000

To Reserve profit b/d
23,284 5,600
46,000 12,000 46,000 12,000

Working Notes
1. Proportion of profit to be transferred to Profit & Loss A/c:
Accounting Profit × (cash received)/(work certified) × 2/3
CONTRACT A:
46,000 × 1,60,000/2,16,000 × 2/3 = Rs. 22,716
CONTRACT B:
12,000 × 80,000/1,00,000 × 2/3 = Rs. 6,400