NATIONAL LAW UNIVERSITY ODISHA

CUTTACK

Project Report on

Contract Costing

In

COST AND MANAGEMENT ACCOUNTING

Submitted To

ASST. PROF. CA. A.B. DEBASIS ROUT

Asst. Professor of Finance

Submitted By

AVINASH GAUTAM (2015BBA.LLB.16)

DEEPAK AGARWAL (2015BBA.LLB.17)

PRIYAM JAIN (2015BBA.LLB.43)

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 ACKNOWLEDGMENT

We would like to expound our solitary word of thank and gratitude to the subject faculty
Assistant Professor of Finance CA. A.B. Debasis Rout for the extravagant, valuable
and formative suggestions, ideas and guidance which he gave during the course of
incepting and developing this piece of research work and in the class lectures.

The sagacity given by him is really admired and greatly appreciated.

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 TABLE OF CONTENTS

ACKNOWLEDGMENT ......................................................................................................... 2
INTRODUCTION ................................................................................................................... 4
COMPARISON BETWEEN JOB COSTING AND CONTRACT COSTING ................. 5
MEANING OF CONTRACT COSTING .............................................................................. 6
RECORDING OF CONTRACT COSTS .............................................................................. 6
PROFIT/LOSS ON INCOMPLETE CONTRACTS.......................................................... 10
COST PLUS CONTRACT ................................................................................................... 11
ESCALATION CLAUSE ...................................................................................................... 12

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 INTRODUCTION

A contract usually takes several years to get itself completed. If the profit on such contracts is
recorded only after their completion, then wide fluctuations may be noted in the profit figures
of contractors from year to year. To avoid these fluctuations in the reported profits and to
reflect the revenue in the accounting period during which the activity is undertaken, the profit
in respect of each contract in progress is transferred to the profit and loss account of the year
by calculating the notional profit. The portion of notional profit to be transferred to the profit
and loss account depends on the stage of completion of a contract. To determine such a profit
figure the knowledge of various concepts as discussed below is essential in contract costing.

Following are the main distinguishing features of contract accounts:

(i) Higher proportion of direct costs:

As most of the items of expenses can be directly identified with a contract, though indirect,
are treated as direct expenses. Expenses on telephone installed at site, site power usage, site
vehicles, transportation are treated as direct expenses.

(ii) Low indirect cost:

The only item of indirect cost may be head office expenses. Such cost represents only a small
proportion of the contract cost and is absorbed usually on some overall basis such as
percentage of total contract cost.

(iii) Difficulties of cost control:

The large scale of contracts and the size of the site may create some major problems of cost
control relating to material usage and losses, pilferage, labour supervision and utilisation,
damage to and loss of plant and tools etc.

(iv) Surplus materials:

Surplus material, if any, will be either credited to the contract account with the cost of
material at the end of the contract or will be debited to the new contract account, if directly
transferred to another contract. If the material is not required immediately, it will be stored
and the cost debited to a stock account.

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 COMPARISON BETWEEN JOB COSTING AND CONTRACT COSTING

There are certain similarities in job and contract costing. Both the methods belong to the
category of specific order costing in which work is executed according to the specification of
customers. Under both the methods customers come on their own and there is no need of
creating demand. Generally quotation price is asked before giving order and production starts
only on receipt of order from the customer. As every job and contract is dissimilar in nature
and is identified by a separate number and is known by that number until it is completed.
Profit is also determined in respect of each job and contract separately. In spite of the above
similarities there are certain differences between job and contract costing.

These are given as under:

1. Size: A job is small in size but the contract is big in size.

2. Place of Work: Work under job costing is performed in the workshop of the proprietor but
the contract is executed mostly at site.

3. Time for Completion: A job usually takes less time for completion of work whereas a
contract takes more time to complete the work.

4. Payment of Price: The selling price of a job is paid in full after completing the job but in
case of a contract, the price is paid in various installments depending upon the progress of the
work

5. Investment: There is heavy investment on assets initially in case of job costing as

compared to contract costing.

6. Nature of Expenses: In job costing, expenses may be direct and indirect but in case of
contract costing, most of the expenses are direct in nature.

7. Transfer of Profit: Profit earned on a job is entirely taken to profit and loss account but in
case of incomplete contract, only proportionate profit is transferred to profit and loss account
depending on the completion stage of the contract.

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8. Nature of industry applicable: Job costing is applied in printing, foundry, engineering
and ship building industries but the contract costing is applied to civil engineering-roads,
bridges, buildings etc.

9. Cost units: Job is the cost unit in job costing hut contract is the cost unit in contract
costing.

10. Contractual obligation: In job costing a job is undertaken as per specification of the
customer and there is a contractual obligation to complete the job in time. There may be a
provision of rejection of defective job and rectification thereof. In contract costing, in
addition to the contractual obligation as given in case of job costing, there is a provision of
retention money and payment to be made according to the work certified.

11. Cost accumulation and variance analysis: It is more complicated in job costing
whereas it is simple in contract costing.

MEANING OF CONTRACT COSTING

Contract or terminal costing, as it is termed, is one form of application of the principles of

job costing. In fact a bigger job is referred to as a contract. Contract costing is usually
adopted by building contractors engaged in the task of executing Civil Contracts. Contract
costing have the following distinct features:

1. The major part of the work in connection with each contract is ordinarily carried out at
the site of the contract.
2. The bulk of the expenses incurred by the contractor are considered as direct.
3. The indirect expenses, mostly consist of office expenses of the yards, stores and works.
4. A separate account is usually maintained for each contract.
5. The number of contracts undertaken by a contractor at a time is not usually very large.
6. The cost unit in contract costing is the contract itself.

RECORDING OF CONTRACT COSTS

Material Cost: All materials supplied from the stores or purchased directly for the contract
are debited to the concerned contract account. In the case of transfer of excess material from

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one contract to other contract, their costs would be adjusted on the basis of material transfer
note, signed both by the transferee and the transferor foreman. In case the return of surplus
material appears uneconomical on account of high cost of transportation, the same is sold and
the concerned contract account is credited with the sale price. Any loss or profit arising
therefrom is transferred to the Profit and Loss Account. Any theft, or destruction of material
by fire represent a loss and as such, the same is transferred to the Profit and Loss Account. If
any stores items are used for manufacturing tools, the cost of such stores items are charged to
the work expenses account. If the contractee has supplied some materials without affecting
the contract price, no accounting entries will be made in the contract account, only a note
may be given about it.

Labour Cost: Labour actually employed on the site of the contract is regarded as direct
(irrespective of the nature of the task performed) and the wages paid to them are charged to
the concerned contract directly or on the basis of a wage analysis sheet (if concurrently a
number of contracts are carried on and labourers are required to devote their time on two or
more contracts).

Direct Expenses: Direct expenses (if any) are directly charged to the concerned contract.

Indirect Expenses: Indirect expenses (such as expenses of engineers, surveyors, supervisors

etc.) may be distributed over several contracts as a percentage of cost of materials, or wages
paid or of the prime cost. If however, the contracts are big, the labour hour method may be
used for the distribution of expenses.

Plant and Machinery : The value of the plant in a contract may be either debited to contract
account and the written down value thereof at the end of the year entered on the credit side
for closing the contract account, or only a charge (depreciation) for use of the plant may be
debited to the contract account.

Sub-Contract : Sub-contract costs are also debited to the Contract Account.

Extra work : The extra work amount payable by the contractee should be added to the
contract price. If extra work is substantial, it is better to treat it as a separate contract. If it is
not substantial, expenses incurred should be debited to the contract account as “Cost of Extra
work”.

Cost of work certified : All building contractors received payments periodically known as
“running payment” on the basis of the architect’s or surveyor’s certificates. But payments are

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not equal to the value of the work certified, a small percentage of the amount due is retained
as security for any defective work which may be discovered later within the guarantee period.

The amount retained is called retention money. The full value of the work certified should be
credited to the Contract Account and debited to the account of the contract. Since the cash
received from him will be less, the balance in his account will be shown as an asset in the
balance sheet.

Work uncertified: It represents the cost of the work which has been carried out by the
contractor but has not been certified by the contractee’s architect. It is always shown at cost
price. The cost of uncertified work may be ascertained as follows :

Retention money : A contractor does not receive full payment of the work certified by the
surveyor. Contractee retains some amount (say 10% to 20%) to be paid, after sometime,
when it is ensured that there is no fault in the work carried out by contractor. If any
deficiency or defect is noticed in the work, it is to be rectified by the contractor before the
release of the retention money. Retention money provides a safeguard against the risk of loss
due to faulty workmanship.

Cash received : It is ascertained by deducting the retention money from the value of work
certified i.e.,
Cash received = Value of work certified – Retention money.

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 Work-in-progress: In Contract Accounts, the value of the work-in-progress consists of

(i) the cost of work completed, both certified and uncertified;

(ii) the cost of work not yet completed; and

(iii) the amount of profit taken as credit.

In the Balance Sheet, the work-in-progress is usually shown under two heads, viz., certified
and uncertified. The cost of work completed and certified and the profit credited will appear
under the head ‘certified’ work-in-progress, while the completed work not yet certified and
the cost of labour, material and expenses of work which has not yet reached the stage of
completion are shown under the head “uncertified” work-in-progress.

Notional profit: It represents the difference between the value of work certified and cost of
work certified. It is determined as:

Notional profit = Value of work certified – (Cost of work to date – Cost of work not yet
certified)

Estimated profit: It is the excess of the contract price over the estimated total cost of the
contract.

Illustration 1

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 PROFIT/LOSS ON INCOMPLETE CONTRACTS

To determine the profit to be taken to Profit and Loss Account, in the case of incomplete
contracts, the following four situations may arise:

(i) Completion of contract is less than 25 per cent: In this case no profit should be taken to
profit and loss account.

(ii) Completion of contract is upto 25 per cent or more than 25 per cent but less than 50 per
cent: In this case one-third of the notional profit, reduced in the ratio of cash received to
work certified, should be transferred to the Profit and Loss Account. Mathematically:

(iii) Completion of contract is upto 50 per cent or more than 50 per cent but less than 90 per
cent: In this case, two-third of the notional profit, reduced by proportion of cash received
to work certified, is transferred to the Profit and Loss Account. Mathematically :

(iv) Completion of contract is upto 90 per cent or more than 90 per cent i.e. it is nearing
completion: In this case the profit to be taken to Profit and Loss Account is determined
by determining the estimated Profit and using any one of the following formulas :

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(This formula may be preferably used in the absence of estimated profit figure).

It is preferable to use formula (b) in the absence of specific instructions.

COST PLUS CONTRACT

Under Cost plus Contract, the contract price is ascertained by adding a percentage of profit to
the total cost of the work. Such type of contracts are entered into when it is not possible to
estimate the Contract Cost with reasonable accuracy due to unstable condition of material,
labour services, etc.

Cost plus contracts have the following advantages and disadvantages:

Advantages:

(i) The Contractor is assured of a fixed percentage of profit. There is no risk of incurring
any loss on the contract.
(ii) It is useful specially when the work to be done is not definitely fixed at the time of
making the estimate.

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(iii) Contractee can ensure himself about ‘the cost of the contract’, as he is empowered to
examine the books and documents of the contractor to ascertain the veracity of the cost
of the contract.

Disadvantages - The contractor may not have any inducement to avoid wastages and effect
economy in production to reduce cost.

ESCALATION CLAUSE

In order to avoid the element of risk from both sides—contractor and contractee, there may
be escalation clause in the contract providing for change in price of the contract due to
change in the utilisation of factors of production beyond an agreed level. In other words, this
is a clause which is provided in the contract to cover up any changes in the price of contract
due to changes in price of raw materials and labour or change in utilisation of factor of
production.

The object of this clause is to safeguard the interest of both sides against unfavourable change
in the price. Thus in a contract with the transport undertaking, the price per ton-mile will
increase or decrease for each rise or fall of price of petrol by 10% of the prevailing price.
Here the contractor has to produce sufficient proof of excess cost before the customer agrees
to reimburse such costs.

Moreover, the basis on which the factor prices are based, is laid down in the contact. In case
the escalation clause is extended to increased consumption or utilisation of quantities of
materials or labour, the contractor has to satisfy the contractee that the increased utilisation is
not due to his inefficiency.

This clause may also stipulate that in the event of prices going down beyond an agreed level,
the contractee would be entitled to a rebate. This is termed as De-escalation Clause.

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Illustration 2:

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Profit to be transferred under various methods

Recommendation: It is recommended that a sum of ` 98,640 may be transferred to the profit

and loss account. This amount is the least and has been arrived by using the formula (iii)
above. According to this formula, profit transferred to the profit and loss account is generally
kept the minimum and allows withholding in reserve a larger portion of notional profit to
meet future unforeseen expenses and contingencies

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Illustration 3

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Note : It is fundamental principle that the contractee would compensate the contractor for the
increase in costs which are caused by factors beyond the control of contractor and not for
increase in costs which are caused due to inefficiency or wrong estimation.

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