Contract Costing Notes
Cost Accounting Notes B. Com 4th Sem CBCS Pattern
Contract Costing Meaning
Contract costing is a special form of job costing used for ascertaining cost and profit on contracts undertaken for big jobs like constructing a building, a road, a bridge or a ship. Such jobs mainly comprise activities outside the contractor’s premises and involve huge amount. They take long time to complete so much so that the work may extend over more than one accounting year. This means that the cost and profit may have to be worked out even on incomplete work as at the end of an accounting year. Hence, a special method of accounting known as ‘contract costing’ or ‘terminal costing’ has been developed for ascertaining cost and profit on such jobs.
Features of Contract Costing
The distinguishing features of contract are as follows:
Features regarding Production
i) The work is undertaken to customer’s specific requirements.
ii) The work will be of a relatively long duration and involves large amount.
iii) The work is usually site based.
iv) The work is frequently of a constructional nature.
v) Plant and equipment may be purchased or hired for the duration of the contract.
vi) The completion date is fixed in advance, and penalties follow delays
vii) Certain aspects of the work are assigned to sub-contractors.
Features regarding Cost
i) The cost unit in contract costing is a contract.
ii) A separate account is prepared for each contract to ascertain the profit or loss on each contract.
iii) Most of the items of cost can be classified as direct since they can be easily identified with a specific contract.
iv) Indirect costs are normally restricted to Head Office expenses and storage costs. These are allocated to various contracts on which work is carried out during the year.
v) The contract price is often fixed in advance and payment is received at various stages of completion based on architect’s certificate.
vi) A separate contract ledger is maintained for recording costs when the number of contracts is large.
Difference between Contract costing and Job Costing
The principals involved in contract costing are the same as those involved in job costing. Certain modifications are to be made in the principles, in some cases, to suit the requirements of particular contracts. In spite of same principles, contract costing differs from job costing on same points mentioned below:
1. Number of jobs in hand at a time may be much greater than the number of contracts in hand at a time.
2. Most of the items of expenses are capable of being directly charged to contract accounts; but direct charging to that extent is not possible in case of jobs.
3. Collection, analysis, apportionment or allocation of cost is simpler in contract costing than in job costing.
4. In case of contracts taking a number of years to complete the question of assessment of profit at the end of each financial year crops up. This question does not arise in case of job costing.
5. Normally, contracts are executed outside the factory, i.e., at customer’s site; but jobs are executed within the factory.
Cost plus Contracts
Where the contractee agrees to pay the contractor, as contract price, the exact cost plus certain percentage thereof to cover overhead expenses and profit, the contract is called cost plus contract.
In case of new type of work where the contractor cannot estimate the cost due to lack of experience in the line, cost plus contract is generally entered into. Government contracts are often on cost plus contract basis.
Since in these contracts the contractor is assured of reimbursement of actual cost, there is no initiative on the part of the contractor to economize. Higher cost means higher profit. So, the contractor is interested in higher cost. On the part of the contractee, therefore, higher supervision cost is involved. The fixed percentage of margin allowed sometimes becomes inadequate and sometimes it becomes excessive.
Main features of cost-plus-contracts:
1. This method is adopted in the case of those contracts where the probable cost of contract cannot be ascertained in advance with a reasonable accuracy.
2. These contracts are preferred when the cost of material and labour is not steady and contract completion may take number of years.
3. The different costs to be included in the execution of the contract are mutually agreed so that no dispute may arise in future in this respect. Under such type of contract contractee is allowed to check or scrutinize the concerned books, documents accounts.
4. Such a contract offers a fair price to the contractee and also a reasonable profit to contractor.
5. The contract price here is ascertained by adding a fixed and mutually pre-decided component of profit to the total cost of the work.
Advantages of Cost Plus Contracts
Costs plus contracts have the following advantages:
The contractor is assured of a fixed percentage of profit. There is no risk of incurring any loss on the contract.
It is useful especially when the work to be done is not definitely fixed at the time of making the estimate.
Contractee can ensure himself about “the cost of the contract”, as he is empowered to examine the books and document of the contractor to ascertain the veracity of the cost of the contract.
Process of estimating profit / loss on incomplete contracts
If the work on a contract is started and finished during the same accounting year, its profit or loss can be easily calculated and transferred to Profit and loss Account. But, in case of contracts which extend to more than one accounting year, the question arises whether any profit or loss should be accounted for during the accounting year or years when they are still in progress and, if so, how? It is agreed that if profit is computed only on the competition of the contract, there will be heavy fluctuation in the amount of profit from year to year. This will result not only in distorted profit pattern but also higher tax liability during the year of completion of the contract because the tax will have to be paid at higher rates. At the same time, if profit is computed on the uncompleted contracts and taken to Profit and Loss Account, there is a possibility of other unforeseen contingencies. Hence, it is an accepted principle that profit on uncompleted contracts must be taken into account in respect of the work certified only after providing adequate reserve for future contingencies.
Rules relating to estimating profit / loss on incomplete contracts
(i)If completion of contract is less than 25% no profit should be taken to profit and loss account.
(ii)If completion of contract is upto 25% or more but less than 50% then
Short Note on Escalation Clause
This clause is usually provided in the contracts as a safeguard against any likely changes in the price or utilization of material and labour. If during the period of execution of a contract, the prices of materials or labour rise beyond a certain limit, the contract price will be increased by an agreed amount. Inclusion of such a term in a contract deed is known as an 'escalation clause'
An escalation clause usually relates to change in price of inputs, it may also be extended to increased consumption or utilization of quantities of materials, labour etc. In such a situation the contractor has to satisfy the contractee that the increased utilization is not due to his inefficiency.