Unit 1 – CONTRACT COSTING

Learning Objectives: The following unit will help the students to understand:

1. The concept and applicability of output costing

2. The components of cost
3. The treatment for stocks and scraps
4. The meaning and types of cost sheet
5. The preparation of production account

Introduction: Contract is a special form of job costing also known as terminal costing. The only
difference between job costing is the size of the job. When the size of the job is big , which
require considerable time to complete and comprising of activities to be done outside the factory
area, the system of contract costing is employed. In this method of costing each contract is a cost
unit and an account is opened for each contract in the books of contractor in order to ascertain
profits. The system is very common with constructional engineers, ship builders etc. who
undertake definite contracts. The contract price is the price agreed to be paid by the contractee to
the contractor. For each contract a separate account is opened in the General ledger or the
contract ledger, which are maintained if there are large number of contracts .The contract
account is debited with all the direct and indirect expenditure in relation to the contract account
and credited with the amount of contract price on the completion of the contract .the balance
represents profit or loss made on the contract and is transferred to the Profit and Loss account.

JOBS WHERE CONTRACT COSTING IS USED:

 Building Construction
 Road construction
 Bridge construction
 Ship building and
 Other civil engineering works.
Features of contract costing: the following are the features of contract costing :

1. The size of the contracts is generally large and hence the number of contracts with the
contractor are less in number.
2. A contract usually takes more than one year to complete.
3. The work on the contract is carried out at the site of the contract and not at the factory
premises.
4. Each contract is considered to represent a cost unit.
5. A separate contract account is prepared in the books of the contractor for each contract in
order to determine profit or loss on each contract.
6. Most of the material is specifically purchased for the contract.
7. Most of the labour and other expenses (telephone, insurance etc.) are direct in nature.
8. Plant and equipment may be purchased or hired for the duration of the contract.
9. Payments to the contractor by the contractee are made at various stages of completion.

Specific aspects of contract costing

(i) Materials – Materials include those items that are purchased specially for the
contract site either issued from store against material requisition note or materials
transferred from one contract to another. The contract account is debited with the
following:
 Materials purchased for the contract
 Materials obtained from the store through material requisition notes
 Materials transferred from one contract to another contract.
 Materials remaining at the site at the end of the accounting period (closing
stock) after valuation of the same and carried forward to the next period
The contract account is credited with the following transactions:
 Materials returned back to the store using the material returned note
 Sale of materials at site
 Materials transferred to other contracts
 Materials lost (stolen or destroyed by fire etc.)
 Any profit or loss on materials account in respect of the following is transferred to the
profit and loss account.
 Sale price is different from the cost price
 Profit or loss due to sale of materials
 Profit or loss due to the materials stolen or destroyed by fire.
(ii) Labour – All labour engaged at site and the salaries and wages paid to the labour are
treated as direct cost and debited to contract account. The salary of supervisory staff
will also be considered as a direct charge against a contract if they have rendered
whole time attention to it. Wages of the workers which cannot be identified with a
particular contract or salary of the supervisory staff looking over two or more
contracts will be considered as indirect expenses and apportioned over the contracts
on reasonable basis.
Wo
rke
r’s
No.

Co
ntr
act
No.
___
__

Co
ntr
act
No.
___
__

Co
ntr
act

No.
___
__

Co
ntr
act
No.
___
__

Occ
upat
ion

Am
ount

Occ
upat
ion

Am
ount

Occ
upat
ion

Am
ount

Occ
upat
ion

Am
ount
Tot
al

Fig.
(iii) Direct expenses: All direct expenses (electricity, insurance, telephone, postage, sub-
contracts, architect’s fees, etc) are treated as direct cost and debited to contract account.
 (iv) Overhead cost: In the case of contract costing, overhead constitute an insignificant part of
the total cost of contract account. Such cost may be apportioned on suitable basis and debited to
the contract account.
(v) Plant & Machinery: the plant used on a contract can be dealt within the contract accounts
in any of the following ways:
(a) Where a plant is specifically purchased for a particular contract and will be exhausted on
site, the contract account should be debited with the cost of the plant. On completion of the
contract, the depreciated value will be credited to the contract account or the contract
account can also be debited with the amount of depreciation calculated. On the completion
of the contract if the plant is sold then sale proceeds are credited to the contract account.
(b) If a plant is used for a contract for a short period, then the contract account should be
debited with the usual depreciation of the plant (there is no need of debiting the cost of the
plant to the contract account).
(vi) Cost plus contracts: in certain contracts the contractee agrees to pay to the contractor the
cost price of the work done on the contract plus an agreed percentage thereof by way of
overhead expenses and profit. such contracts are known as cost-plus contracts.The system of
cost plus contract costing is employed in case where it is very difficult for the contractor to
quote the contract price because there is no precedent which may be taken as the basis. This
method is generally used when it is the government that is the contractee. The basic
advantage of this method is fixed profit.
(vii) Sub-contractor: the contractor may entrust certain portion of work under the contract to a
sub contractor .such work is usually specialised in nature (eg. special flooring, steel works
etc.) assigned by the contractor to the sub –contractor who is responsible to the main
contractor for the work assigned to him. This special work done by the sub-contractor
becomes a direct charge to the main contract and accordingly debited to the contract account.
(viii) Work-in-progress (work certified & work uncertified)- in the case of the small contracts the
contractee pays the contract price on the completion of the contract. in case of large contracts
Progress Payment is adopted. the contractee agrees to pay part of the contract price from time to
time depending upon the satisfactory progress of the work. the work shall be judged by
contractee’s architect, surveyor or engineer who will issue certificate stating the value of work
done so far and approved by him .such work is known as work certified .the contractee usually
pays 75% or 80% of the value of work certified depending upon the terms of the contract .the
balance not paid is known as Retention Money.
The value of the work certified and consequent payment is dealt in any of the two ways:
(a) The value of work certified is debited to the contractee’s personal account and
credited to the contract account.on the receipt of money the contractee ,his personal
account is credited and cash or bank account is debited . For example the value of
work certified is Rs.50,000 and contractee has paid 80% in cash the following
journal entry shall be passed.
Contractee’s A/c Dr. Rs.50,000
To Contract A/c Rs.50,000
(Being the value of work certified)
Bank A/c Dr. Rs.40,000
To Contractee’s A/c Rs.40,000
(Being the amount of cash received)
In the balance sheet the contractee’s account is shown on the asset side .It it to be
carefully observed that the value of work certified should not include Rs.40,000as
the entry for the same has already been passed.
(b) The cash received from the contractee is credited to his personal account. The value
of work is debited work in progress a/c and credited to the contract account. The
work in progress is shown as an asset in the balance sheet after deducting the amount
received from the contractee. In the beginning of the next year the work in progress is
transferred to debit side of contract account. On completion of the contract the
contractee’s personal account is debited and contract account is credited.
Work in progress A/c Dr. Rs.50,000

To Contract A/c Rs.50,000

(Being the value of work certified)

Bank A/c Dr. Rs.40,000

To Contractee’s A/c Rs.40,000

(Being cash received from the contractee)

In the Balance Sheet the items will appear as follows:

 BALANCE SHEET AS ON----------

As
sets

Am
oun
t

(Rs
.)

Wo
rk
in
pro
gre
ss(
Co
ntr
act
No.
----
)

50,
000

Les
s:
Am
oun
t
rec
eiv
ed
fro
m
the
con
trac
tee
40,
000

10,
000

Work uncertified: If the progress of a work is unsatisfactory or the work has not reached the
stipulated stage, though certain work is completed, such work does not qualify for a
certificate by the Contractee's Architect or Surveyor is termed as "Work Uncertified." It is
valued at cost and credited to Contract Account and debited to Work in Progress Account
which will be transferred to the debit of the contract account at the beginning of the next
year. The Work in Progress Accountwill appear as follows in the balance sheet.
BALANCE SHEET AS ON ---------------
As
sets

Am
oun
t(R
s.)

Wo
rk
in
pro
gre
ss:

val
ue
of
wor
k
cert
ifie
d
x

Ad
d:
cos
t of
wor
k

unc
erti
fied
x
xx

Les
s;
Am
oun
t

rec
eiv
ed
fro
m
con
trac
tee

Les
s;
Res
erv
es
for
unr
eali
zed
pro
fit
xx

The value of work in progress can be ascertained as under:

Cost of work certified x
Add: Cost of work uncertified x
Cost of work to date x
Add: Profit taken to P&L A/c x___________
It is to be observed that profit made on contract in progress is the excess of the value of work
certified over its cost.a part of such profit is kept as reserve while the other is taken to Profit and
Loss A/c.

Treatment of Profits
or Loss on
Contracts A/c.

Profit or Loss on
Profits or Loss on
incomplete
completed contracts
contracts

(A) Profit or Loss on Incomplete Contracts

At the end of the accounting period there would be certain completed contracts and while
others are still in process and will be completed in the coming years.The total profit made on
 completed contracts may be taken safely to the Credit of Profit and Loss A/c.But in case of
the contracts in process there is possibility of profits being turned into losses due to rise in
the prices of material and labour and losses on account of unforeseen contingencies.Henc, it
is important to consider profit on in completed contracts after providing for the unknown
contingencies.
In the case of incomplete contracts, the following situations may arise :
(i) Profit should be considered in respect of work certified only, work uncertified should
always be valued at cost.
(ii) Completion of Contract is Less than 25% : In this case no profit should be taken to Profit
and Loss Account.
(iii) Completion of Contract is upto 25% or more but Less than 50% : In this case one-third of
the notional profit, reduced in the ratio of cash received to work certified, should be
transferred to Profit and Loss Account. The balance should be allowed to remain as reserve.
It can be expressed as :
1 Cash Received
× 𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 ×
3 Work Certified
(iv) Completion of Contract is upto 50% or more : In this case two-third of the notional
profit reduced by proportion of cash received to work certified is transferred to Profit
and Loss Account. The equation is:
2 Cash Received
× 𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 ×
3 Work Certified
(v) Completion of Contract is upto 90% or more than 90%, 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 anyone of the following formula :
Work Certified
(a) 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡 ×
Contract Price
Work Certified Cash Received
(b) 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡 × ×
Contract Price Work Certified

𝑜𝑟
Cash Received
(c) 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡 ×
Contract Price
Cost of Work to Date
(d) 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡 ×
Estimated Total Cost
 Cost of Work to Date Cash Received
(e) 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡 × ×
Estimated Total Cost Work Certified
Work Certified
(f) 𝑁𝑜𝑟𝑚𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 ×
Contract Price
(vi) The whole of loss if any ,should be transferred to Profit and Loss Account.
(vii) As per Accounting Standard(Revised):While accounting for construction contracts a
foreseeable loss on the entire contract should be provided for in the financial
statements irrespective of the amount of work done and the method of accounting
followed.hence,the profit earned or realised is a deemed or notional profit on the basis
of work certified ,and is generally reduced on the basis of cash received as the
principle of conservatism is followed .The accounting entry for the transfer of profit
to the profit and loss account and Work in progress account for unrealised profit will
be as under:
Contract A/c(with total profit) Dr.
To Profit and Loss A/c(with profit transferred)
To Work-in-Progress A/c(with profit kept as reserve)
(B) Profits or Loss on completed contracts :When the contract is complete the
contractee’s account is debited and contract account is credited with the contract price.
As there is no work in progress the entire profit or loss is transferred to Profit and Loss
A/c. The balance of retention money in respect of work certified earlier is also received.
Hence, the contractee account and the contract account all stand closed.

Contract account is a nominal account and its main purpose is to estimate the profit
earned each year in case of contracts whose tenure or period of completion exceeds one
year.
Dr. CONTRACT A/c Cr.
To Materials
a. Purchased directly By materials returned
b. Issue from site
c. Supplied by contractee