What is Contract Costing? – Definition
Contract costing is the method of costing which is applied in a business where separate contracts of non-repetitive nature are undertaken. According to Sharie, “Contract or terminal cost accounts are applicable to a concern which makes specific contracts and requires to know the cost of each.”
A contract is a job of large size may extend even beyond one accounting period. The person executing the contract is known as a Contractor and the person for whom it is executed is known as Contractee.
Contract costing is a special form of job costing wherein big jobs are involved which requires considerable time to complete and comprises a lot of activities. Herein a separate account is opened for each contract in the Contract Ledger (or in General Ledger). The account is debited with all direct and indirect expenses and is credited with the amount of contract price on completion of the contract. The balance of this account is transferred to Profit and Loss Account. However, if the contract is not completed before the end of the accounting period, a reasonable amount of profit (or logs) is transferred to Profit and Loss Account.
Specific Aspects of Contract Costing
Materials. Here three specific accounting may be required to be done. In case materials are purchased for the contract and directly delivered at the site of the contract, naturally, there arises no specific accounting system. However, if the materials purchased are, first, delivered to the stores department, then the contract account will be debited and Store control account will be credited. If however, certain materials are charged to contract account but returned to stores, stores contract account will be debited and the contract account will be credited.
Materials sold at the contract site is credited to the Contract Account. However, if because of some extraneous reasons sale is made then the profit or loss incurred due to such a sale is credited to Profit and Loss Account. In case of sale of contract assets and property also for profit or loss the Profit and Loss Account is credited.
In some cases, the contractee may himself supply the materials to the contractor. Here also the value of such materials should not be charged to the contract account. The unused materials are to be returned to the contractee.
Labor. All labor employed for the completion of the contract is direct labor and is treated as such. For maintaining a proper record and for having control over the labor expenses the wages abstract is prepared.
Plant and Machinery. Where a plant, machinery or equipment is specially purchased for a particular contract and will be exhausted at the site. If it is so it will naturally be debited in the contract account and any amount of depreciation shall be charged to the credit side of the contract account. However, if it is acquired for a shorter period; then, the amount is debited only with the usual depreciation of the assets. The sale proceeds, if any, at the end or mid-way of the contract is credited to the contract account and profit or loss on such a sale is transferred to Profit and Loss Account.
Indirect Expenses. Indirect expenses are, treated and apportioned in the same manner in which they are treated and apportioned in any costing system. If on three contracts No. 1, 2 and 3 $3,000, $2,000 and $1,000 have been spent respectively for materials, labour and plant and indirect expenses are $1,200, the share in indirect expenses of contract No. 1, 2 and 3 will be $600, $400 and $200 in the ratio 3 : 2 : 1 respectively.
Cost plus contract is one wherein the contractee agrees to Pay to the contractor the cost price of the work done on the contract plus an agreed amount or percentage thereof by way of different overheads and profit.
Extras. The agreement may be there to charge extra money for any addition (s) or alteration (s) to be made in the work originally agreed to be done under a particular contract. In such a case the extra money becomes payable to the contractor by the contractee for all such subsequent additions and alterations.
Sub-contracts. The contractor (if thinks proper and allowed to do so by the agreement entered into) may entrust some portion of the work to be done by one or more than one sub-contractor. The cost in this connection is the direct charge on the contract and is treated as such in the contract costing.
Escalation Clause. In a contract agreement, there is a usual practice of making a provision for the escalation clause the contractor is interested in safeguarding himself against any charge in the price level. The agreement itself specifies the procedure for the calculation of adjustment in order to avoid all disputes etc.
Payment. In case of small contracts, the usual practice is to make the payment to the contractor in lump sum after the completion of the contract. However, in large contract the payment is made in instalment on the basis of progress made in the contract. The progress is judged by technical personnels —architect, survey. or, engineer, etc.
Such personnels are required to issue a certificate certifying the complete work. Such work for which certificate is granted is known as Work Certified which may be expressed in terms of percentage. Here also the contractee may not pay for 100% work certified. He may withheld or retain some payment. This is called retention money. The work for which certificate is not granted is known as work uncertified.
The following are the ways in which the value of work certified is treated in cost accounts:
(1) The amount of work certified is debited to the Contractee’s Personal Account and Contract Account is credited.
(2) Cash or Bank Account is debited and Contractee’s Personal Account is credited or receipt of the money for certified work.
(3) Balance of Contractee’s Personal Account is shown as an asset in the Balance Sheet.
(1) A memorandum record of work certified may be kept.
(2) The amount received from the contractee may be debited to his personal account.
(3) The amount of the work certified may be debited to the Work-in-Progress Account and credited to the Contract Account.
(4) On completion of the contract, the Contractee ‘s Personal Account may be debited and the Contract Account may be credited.
Profit on Incomplete Contracts. If the contract is not complete and the accounting year has come to close then profit on incomplete contracts is required to be calculated and accounted for. In this respect the following rules may be followed:
(1) In respect of work certified the profit should be calculated and accounted for. Work uncertified should be valued at cost.
(2) If the work certified is less than 25% of the contract price, the profit should neither be calculated nor accounted for.
(3) If the work certified is more than 25% of the contract price but it is less then 50% of the contract price, then, of the profit disclosed, as reduced by the percentage of cash received from the contractee, should be shown in the Profit and Loss Account. The balance naturally is to remain as a Reserve.
(4) If, however, the certified work is more than 50%, the 66-2/3% of the profit disclosed, as reduced by the percentage of cash received from the contractee, should be shown in the Profit and Loss Account. The remaining be shown and kept as a reserve.
(5) If the contract is nearing completion, the total cost of contract be estimated and the estimated total profit on the contract should be calculated by deducting the total estimated cost from the agreed total contract price and Profit and Loss Account, then, be credited by the proportion of total estimated profit vis.a.vis cash received from the contractee.
(6) The loss, if any, shall naturally be transferred to Profit and Loss Account.
Features of Contract Costing
The main features of Contract Costing may be summarised as follows:
- Contracts are executed at contract site away from executor’s or contractor’s premises.
- Contracts are jobs of large size and may continue over more than one accounting period.
- Each contract is treated as a separate unit of cost for the purpose of cost ascertainment.
- The contracts are executed as per the specifications given by the contractee.
- Since the work is executed at the contract site, most of the items of cost to be incurred are direct in nature.
- The contract is executed by the contractor for some agreed amount of consideration known as Contract Price.
- The payments by the contractee are made to the contractor in installments on the basis of the extent of the work already completed by him and certified as complete by contractee’s engineer or architect.
Contract costing is most suitable to ship-building, road construction, building construction, civil engineering works, etc.
Difference between Contract Costing, Job Costing and Terminal Costing
Contract Costing, Job Costing and Terminal Costing do not differ from each other so far as the nature of the work involved is concerned. But contract costing differs from job costing in as much as a contract is executed at the site outside the factory premises of the contractor, whereas a job is executed by the contractor inside his factory premises.
Moreover, the ascertainment of the cost of a contract is very simple as compared to the ascertainment of the cost of a job. A contract is executed at the site of the contract outside the factory premises and as such most of the expenses incurred by the contractor in its execution are direct in nature. A job is performed inside the factory premises where a number of different jobs are completed simultaneously and a number of items of indirect expenses have to be apportioned to these jobs on some equitable basis.
Contract costing and job costing differ slightly from terminal costing as in case of terminal costing a deadline is fixed by the contractee within which a job or contract must be completed failing which the contractor shall pay damages to the contractee on account of loss suffered by him due to the delay in the completion of the job or contract.
Objects of Contract Costing
The main objects of Contract Costing are:
(i) to ascertain the total cost of a contract, and
(ii) to ascertain the profit or loss on the contract.
Procedure of Contract Costing
A contractor maintains a Contract Ledger in which a separate account is opened for each contract undertaken by him. The Contract Ledger should be ruled out as to give maximum information.
A specimen ruling of the Contract Ledger is given below: