Contract costing is a method used to track costs associated with long-term, large-scale projects like construction, engineering, and shipbuilding. It involves attributing all costs to a specific contract, including materials, labor, and overheads. Typically, these contracts are formal agreements, executed over an extended period, and involve specialized work tailored to the client’s requirements. Unlike job costing, contract costing deals with projects of a longer duration and often includes on-site work. The method is crucial for assessing work-in-progress, determining notional and estimated profits, and managing payment terms such as retention money and escalations.
Table of Contents
- Introduction
- Important Definitions
- Important Formulas
- Frequently Asked Questions (FAQs)
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1. Introduction
Contract Costing is a form of specific order costing where costs are attributed to contracts.
1.1 Essential features of contract costing
- A formal contract is made between customer and supplier.
- Work is undertaken to customers’ special requirements.
- The work is for a relatively long duration.
- The work is frequently constructional in nature.
- The method of costing is similar to job costing.
- The work is frequently based on site.
- It is not unusual for a site to have its own cashier and timekeeper.
1.2 Types of Contracts
- Cost-Plus Contracts: Cost-plus contract is a contract where the value of the contract is determined by adding an agreed percentage of profit to the total cost. These types of contracts are entered into when it is not possible to estimate the contract cost with reasonable accuracy due to unstable condition of factors that affect the cost of material, employees, etc.
- Target-price contracts: In such cases, the contractor receives an agreed sum of profit over his pre-determined costs. In addition, a figure is agreed as the target figure and if actual costs are below this target, the contractor is eligible for bonus for the savings.
2. Important Definitions
2.1 Cost of Work Certified or Value of Work Certified
A contract is a continuous process and to know the cost or value of the work completed as on a particular date; assessment of the completion of work is carried out by an expert (it may be any professional like surveyor, architect, engineer etc.). The expert, based on his assessment, certifies the work completion in terms of percentage of total work. The cost or value of certified portion is calculated and is known as Cost of work certified or Value of work certified respectively. Payment is made on the basis of work certified.
2.2 Cost of Work Uncertified
It represents the cost of the work which has been carried out by the contractor but has not been certified by the expert. It is always shown at cost price. There is no role of work uncertified in payment.
2.3 Work-in-Progress
It costing refers to the work which is not complete on the reporting date.
Value of the work-in-progress = the cost of work completed, both certified and uncertified + the cost of work not yet completed + amount of estimated/notional profit (reserve for contingencies). [amount received from the contractee is subtracted from the WIP in the Balance Sheet]
2.4 Retention Money
In a contract, a contractee generally keeps some amount payable to contractor with himself as security deposit. To ensure that the work carried out by the contractor is as per the plan and specifications, it is monitored periodically by the contractee. This security money upheld by the contractee is known as retention money.
Retention money = Value of work certified- Payment made to contractor.
2.5 Notional Profit
It represents the difference between the value of work certified and cost of work certified.
2.6 Estimated Profit
It is the excess of the contract price over the estimated total cost of the contract. [can be calculated and feasible to calculate only in case of contracts whose end is near].
2.7 Escalation Clause
In order to protect the contractor from the rise in the price, an escalation clause may be inserted in the contract. Escalation clause in a contract empowers a contractor to revise the price of the contract in case of increase in the prices of inputs due to some macroeconomic or other agreed reasons. As per this clause, the contract price is increased proportionately if there is a rise in input costs like material, labour or overheads.
3. Important Formulas
Degree of completion of the contract (%) = Work Certified × 100/Contract Price
Formulas for transfer of Profit/Loss to Profit and Loss Account
If the contract is in its early stages:
No profit should be credited to Profit and Loss Account.
As a general rule, no profit should be recognised unless a contract is at least 25% complete.
If the contract is reasonably advanced:
In this case the portion of notional profit to be transferred to Profit & Loss Account is based on the degree of completion of the contract.
1. If the degree of completion of work is above 25% but less than 50% of total work
1/3 × Notional Profit × Cash Received/Work Certified
2. If the degree of completion of work is more than or equal to 50% of the total work but less than 90%,
2/3 × Notional Profit × Cash Received/Work Certified
If the contract is almost complete (Degree of composition is 90% or more):
- Estimated Profit × Work Certified/Contract Price
- Estimated Profit × Work Certified/Contract Price × Cash Received/Work Certified
- Estimated Profit × Total Cost to date/Estimated Total Cost
- Estimated Profit × Total Cost to date/Estimated Total Cost × Cash Received/ Work Certified
When an incomplete contract reveals a loss:
The whole amount of the loss must be charged to the profit and loss account of the accounting year.
4. Frequently Asked Questions (FAQs)
FAQ 1. What are the treatment of profits on incomplete work in contract accounts?
Treatment of profits on incomplete work in contract accounts:
- In case of contracts which are less than 25% complete, on profits should be taken into consideration and consequently no credit should be taken to Profit and Loss Account.
- In case of contracts which are more than 25% complete, but less than 50% complete, the following method should be used for computing the profit to be credited to the Profit and Loss Account:-1/3 x Notional Profit x Cash Received/Work Certified.
Notional Profit is the difference between the value of work certified and cost of work certified. It is computed in the following manner. Notional Profit = Value of work certified – [cost of work to date – cost of work completed but not certified]. - In case of contracts complete between 50% and 90% [more than 50% but less than 90%] the following method is used for computing the profit to be credited to the Profit and Loss Account:- 2/3 × Notional Profit × Cash Received/Work Certified.
- In case of contracts completed 90% or more than that, it is considered to be almost complete. In such cases, the estimated total profit is first determined by deducting the total costs to date and additional expenditure necessary to complete the contract from the contract price.
The portion of profit so arrived is credited to the Profit and Loss Account by suing any of the following formula:—
Method I – Estimated Profit × Work Certified/Contract Price
Method II – Estimated Profit × Work Certified/Contract Price × Cash Received/Work Certified or Estimated profit × Cash Received/Contract Price
FAQ 2. What are the advantages of cost plus contract?
Advantages of Cost Plus contract:
The advantages of cost plus contract are discussed below: —
- It protects the contractor from the risk of fluctuation of price of factor of production.
- Reasonable profit of the contractor is ensured as such profit is added to the actual cost incurred by him to determine the price of the contract.
- The contractor pay a fair price for the work as price is based on actual cost which can be verified by the contractee from the books and documents of the contractor.
- At the time of unstable conditions this type of contract is most advantageous both to the contractor and the contractee.
FAQ 3. What is Retention money in contract costing?
- Usually the contractee stipulates in the contract deed that he would withhold a part of the contract price to be paid at a later stage after completion of the contract.
- This is to make sure that the contractor has performed all work relating to contract on the most satisfactory manner and that no repair work arises within a prescribed time limit.
- The amount so withheld by the contractee is known as retention money.
- It safeguards the interest of the contractee against the contractor, who may at time perform sub-standard work and gain therefrom.
- This is done on the value of contract completed and certified by the architect/surveyor appointed by the contractee.
- The retention money will be paid once the contract is completed to the customer’s satisfaction.
- The main advantage of Retention Money is safeguarding the contractee against the default risk of contract.
FAQ 4. What is Cost Plus Contract?
- In this type of contracts the contractor is usually entitled to a stipulated amount of profit in addition to actual cost of the service.
- The amount of profit to be added to the actual cost of contract may be in the form of fixed amount on a percentage on actual cost.
- This type of contract is generally entered into for executing special type of work which is not usually undertaken by the contractor.
- Examples of this type of contracts are construction work during war, production of newly designed ship, etc. This type of contract is advantageous both to the contractor and the contractee.
- Contractor generally receives a reasonable profit. He is protected from any loss or unusual risk.
- Contractee can ensure a fair price of the contract because the contractee is entitled to verify the books of contractor.
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