Contract Costing of Indian

Security Force
Introduction to Contract Costing
Contract costing is the tracking of costs associated with a specific contract with a
customer. For example, a company bids for a large construction project with a
prospective customer, and the two parties agree in a contract for a certain type of
reimbursement to the company. This reimbursement is based, at least in part, on
the costs incurred by the company in order to fulfill the terms of the contract. The
company must then track the costs associated with that contract so that it can justify
its billings to the customer. The most typical types of cost reimbursement are:

 Fixed price: The company is paid a fixed total amount for completing the
project, possibly including progress payments. Under this arrangement, the
company will want to engage in contract costing to compile all of the costs
relevant to the construction project, just to see if the company earned a profit
on the deal.
 Cost plus: The company is reimbursed for the costs it incurred, plus a
percentage profit or fixed profit. Under this arrangement, the company will be
forced under the terms of the contract to track the costs related to the project,
so that it can apply to the customer for reimbursement. Depending on the
size of the project, the customer may send an auditor to examine the
company's contract costs, and may disallow some of them.
 Time and materials: This approach is similar to the cost plus arrangement,
except that the company builds a profit into its billings, rather than being
awarded a specific profit. Again, the company must track all contract costs
carefully, since the customer may review them in some detail.
Contract costing can involve a considerable amount of overhead allocation work.
Customer contracts typically specify exactly which overhead costs can be allocated
to their projects, and this calculation may vary by contract.

In some industries, such as government contracting and commercial construction,

contract costing is the primary task of the accounting department, or may even be
organized as an entirely separate department. Proper contract costing can
contribute a considerable amount of profits, and so is typically staffed with more
experienced contract managers and accountants.

Meaning of Contract Costing

Contract costing is the tracking of costs associated with a specific contract with a
customer. Contract costing can involve a considerable amount of overhead
allocation work. Customer contracts typically specify exactly which overhead costs
can be allocated to their projects, and this calculation may vary by contract.

In some industries, such as government contracting and commercial construction,

contract costing is the primary task of the accounting department, or may even be
organized as an entirely separate department. Proper contract costing can
contribute a considerable amount of profits, and so is typically staffed with more
experienced contract managers and accountants.

Definition of Contract Costing

Contract Costing is a special type of job costing where the unit of cost is a single
contract. The contract itself is a cost center and is executed under the customer’s
specifications. Contract costing is a variant  of job costing  system applicable
particularly in case of the organization’s doing construction  work.  It is  also  known
as terminal costing. Each contract, short term or long term is treated as a job.
“Contract or terminal costing is the term applied to the system adopted by those
businesses which carry out substantial building or constructional contracts.” —
Walter W. Bigg
Features of Contract Costing
Contract costing has certain distinctive features. The important features of contract
costing are:
 Contracts are generally of large size and, therefore, a contractor usually
carries out a small number of contracts in the course of one year.
 A contract generally takes more than one year to complete.
 Each contract undertaken is treated as a cost unit.
 Separate Contract Account is prepared for each contract in the books of
contractor to ascertain profit or loss on each contract.
 Payments by the contractee are made at various stages of completion of the
contract based on E-stamp certificate for the completed stage. An amount
known as retention money is withheld by the contractee as per agreed terms.
 Penalties may be incurred (paid) by the contractor for failing to
 Complete the work within the agreed period.
 Contract costing is less detailed and simpler than job costing.
 Each contract or work involved in contract costing is executed or done as per
the specifications given by the contractee. So one contract may be dissimilar
to another contract.
 As the contract is undertaken at the contractee’s promises most of the items
of cost chargeable to a contract are direct costs. Indirect costs are very few.
 In the case of contract costing, work commences on receipt of order from the
customer.
 In case of complete contract, there is the problem of determination of the
amount of profit to be carried to current year’s Profit and Loss Account, and
the amount of profit to be carried forward.
 There is no heavy investment on assets initially in the case of contract
costing.

Contract Costing Procedure:

The basic procedure for costing of contracts is as follows:
1. Contract Account:
Each contract is allotted a separate number and a separate account is
opened for each contract.
2. Direct Costs:
Most of the costs of a contract can be allocated direct to the contract. All
such direct costs are debited to the Contract Account.
Direct costs for contract include:
(i) Direct cost of labour,
(ii) Direct labour and supervision,
(iii) Direct Expenses,
(iv) Sub-contract costs, etc.
3. Indirect Costs:
Contract cost is also debited with overheads which tend to be small in
relation to direct costs. Such costs are often absorbed on same arbitrary
basis as a percentage on labour cost or wages, etc. Overheads are normally
restricted to head office and labour costs.
4. Transfer of or Plant:
When materials, plant or other items are transferred from the contract, the
Contract Account is credited by that amount.
5. Contract Price:
The Contract Account is also credited with the contract price. However, when
a contract is not complete at the end of financial year, the Contract Account
is credited with the value (cost) of work-in-progress as on that date. Work- in-
progress includes value of work certified and the cost of work uncertified.
6. Profit or Loss Account:
The balance of Contract Account represents profit or loss which is transferred
to Profit and Loss Account. However, when contract is not completed within
the financial year, only the part of the profit arrived is taken into account
andthe remaining profit is kept as reserve to meet any contingent loss on the
complete portion of the contract.
Computation of Profit or Loss on Contract:
There may be three situations in the computation of profit or loss on
contracts. They are:
(I) Profit on completed contracts,
(II) Profit on uncompleted contracts,
(III) Profit on likely to be completed contracts.
i. Profit on Completed Contracts:
If a contract is begun and completed in the same financial year, then,
the entire profit or loss made on such a contract should be transferred
to the Profit and Loss Account. If there is profit, the same should be
credited to the Profit and Loss Account and debit should be given to
Contract Account. On the other hand, if there is loss, the same should
be debited to the Profit and Loss Account and credit being given to the
Contract Account.
ii. Profit on Uncompleted Contracts:
Contracts which are started and finished during the same financial
year create no accounting problems. But in case of those contracts
which take more than one year to complete, a problem arises whether
profit on such contracts should be worked out only on the completion
of the contract or at the end of each financial year on the partly
completed work. If profit is computed only on the completion of the
contract, profit will be high in the year of completion of the contract,
where as in other years of working on contract, profit will be nil.
This would result not only distorted profit pattern but also higher tax
liability because income-tax at higher rates may have to be paid.
Therefore, when contracts extend beyond a year, it becomes
necessary to take into account the profit earned or loss incurred oh the
work performed during each year. This helps in avoiding distortion of
the year-to-year profit trend of the business.
iii. There are two aspects of the profit computation:
(1) Computation of notional profit or estimated profit, and
 (2) Computation of the portion of such profit to be transferred to Profit
and Loss Account.
The portion of the notional or estimated profit to be transferred to Profit
and Loss Account depends upon the stage of completion of the
contract. Prudence requires that the total notional profit should not be
transferred to Profit and Loss Account but a portion of it should be
withheld as a reserve to meet any unforeseen future expenses or
contingencies.

Types of Contracts in Contract Costing

Generally, there are two types of contract:
1. Cost-plus contract
Cost Plus Contract is a contract in which the value-of-the contract is ascertained by
adding a fixed margin of profit to the total cost of the contract.
In this case, the manufacturer is assured of a certain percentage of profit in advance
and is protected against any fluctuations in the market prices of the various cost
elements involved in the production.
As a result of the viewpoint of the manufacturer, the possibility of incurring any loss is
eliminated.
Advantages of the Cost Plus Method of Contract:
(A) Advantages to the Contractor:
 Free from losses.
 Certainty of profits in case of increasing prices of labour .
 In times of uncertainty execution of contract becomes possible.
 Free from getting approval of tender price.
 In case of urgency of execution of a contract.
 Availability of the services of experts and labour.
(B) Advantages to the Contractee:
 Quick completion of work.
 Quality work.
 Easy to get the work done in emergency.
 Disadvantages of Cost Plus Contract Method:
 Generally contract price is increased under this method.
 Excessive increase in expenses, since contractor is not worried about
increasing cost.
 Uneconomic use of raw material and labour by contractor.
 Limited income to the contractor.
 Monotonous in contractor.
2. Fixed Price Contract
Under Fixed-Price Contract the contractor and the contractee both parties agree to a
fixed contract price.
In this case, the manufacturer is not assured of a certain percentage of profit in
advance and is not protected against any fluctuations in the market prices of the
various cost elements involved in the production.

Difference between Job Costing and Contract

Costing
The difference between job costing and contract costing are:
1. Size
Job costing refers to very small work while contract costing refers to large work like
building a bridge.
2. Recording of expense
All kinds of expenses are not charged to the job account. All kinds of expenses
either direct or indirect are charged to the contract account.
3. Profit Determination
Under job order costing profit is determined after all cost related to the job is
incurred.
But under contract costing as it is operated for several years so each year-end an
estimated profit is determined which is known as notional profit.
4. Complexity in accounting
Under job order costing Complexity in accounting is lower. But Under contract
costing Complexity in accounting is high.
 5 Work Place

Under job order costing work is done in the company’s factory. But Under contract
costing work is done in the worksite.

6 Payroll

The payroll is prepared either at the site or at a central administrative office.

7. Control
The scale of operations and cost control becomes difficult due to the theft of
materials, labor time utilization, pilferages, etc.

Why is the profit of incomplete contract

ascertained?
Profit in respect of each contract during every financial year can be ascertained.
While there is no controversy as to the treatment of loss incomplete contract there is a
controversy as to the treatment of profit on the incomplete contract.
The loss on incomplete contract in any year should, however, be transferred to the
year’s Profit & Loss Account.
So, on the conservative approach, the work-in-progress are valued at cost only.
No portion of the profit, if any, is included in the value of work-in-progress. The
arguments in favor of this approach are:
a) Until a contract is completed, nobody can say that ultimately there will be profit.
So, profit it any year before completion is nothing but anticipated profit.
b) If profit is considered, income-tax shall be payable on that profit much earlier
than the year of completion.
c) A contract may show a profit during earlier years of execution, but ultimately it
may prove loss. Dividends paid on this basis of profit in earlier years shall be
ultimately unjustified.
How the Profit of Incomplete Contract is
Determined
The treatment of profit on incomplete contracts is given below:
a) Profit should be considered in respect of work certified only; work uncertified
should always be valued at cost.
b) If the work started recently and one-fourth or less is done no profit should be
transferred to profit and loss account.
c) If the contract has advanced and if the architect of the contractee certifies that
the work completed more than 25%, in that case, one-third of notional profit
should be recognized as profit.
PROFIT=1/3* cash received/work certified.
NOTIONAL PROFIT = Value of work certified-(cost of work to date-uncertified
amount)
d) If the contract is done more than 50% but less than 90% in that situation two-
third of notional profit should be recognized as profit.
Profit = Notional profit *2/3*cash received /work certified.
e) If the contract is done 90% or more in that situation total profit may be
recognized.

Rules:
There are no hard and fast rules in this regard. However, the following general rules
may be followed in this context:
1. First Rule:
When work certified is less than 1/4 of the contract price, no profit is transferred
to Profit and Loss Account. This is based on the principle that no profit should be
taken into account unless the contract has reasonably advanced.
2. Second Rule:
When work certified is 1/4 or more but less than 1/2 of the contract price, then
generally 1/3 of the profit is transferred to Profit and Loss Account. The balance
amount is treated as reserve. Thus, profit to be transferred to Profit and Loss
Account is computed by the following formula –
3. Third Rule:
When work certified is 1/2 (i.e. 50%) or more but less than 9/10 (i.e. 90%) of the
contract price, then the profit to be transferred to Profit and Loss Account is
computed by the following formula –

4. Fourth Rule:
When contract is near completion then the estimated profit should be calculated
on the whole contract. The proportion of estimated profit to be transferred to
Profit and Loss Account is computed by any one of the following formulas:

5. Fifth Rule – Loss on Uncompleted Contracts:

In the event of a loss on uncompleted contracts, this should be transferred in full
to the Profit and Loss Account. Whatever be the stage of completion of the
contract.

Important Matters to be Taken into

Considerations While Solving Problems
of Contract:
The following important matters must be taken into consideration while solving
problems concerning contracts:
1. First of all, the students should see that what accounts have been asked to be
prepared. It is only contract account or contract account along-with Work-in-
progress Account and Contracts Account. It should be further seen that balance
sheet has been instructed to be prepared or only work-in-progress account has
been asked to be shown in Balance Sheet?
2. Look at the date of beginning the contract and preparation of contract account,
so that it can be ensured that for how much duration the particular contract is
being prepared.
3. Ensure whether the contract has been completed or is incomplete so far. In case
of incomplete contract, determine how much proportion of completed contract
bears to contract price. Is completed work less than 1/4 of contract price or is
equal to 1/4 or more but less than 1/2 of contract price or is equal to 1/2 or more
but less than 9/10 of contract price or is about to be completed. This information
is required to decide how much of profit earned could be credited to Profit and
Loss Account.
4. As regards depreciation read carefully whether the term ‘per annum’ (p.a.) has
been used with the rate of depreciation. If yes, then look at the period for which
the plant and machinery has been used on the contract. If the word ‘p.a.’ has
been used, then depreciation shall be calculated proportionately to the period the
plant was in use on contract. If the term ‘p.a.’ is not used, then depreciation shall
be calculated for one year. In such a case, the period of use of plant and
machinery on contract shall not be considered.
5. If the contract is in the stage of completion, then estimated profit will have to be
ascertained.
6. If the amount of work certified is not given, it will have to be ascertained. It is
ascertained on the basis of amount received from contractee as a fixed
percentage of work certified.
7. The value of uncertified work is always shown at cost, not at contract price. All
expenses incurred by the contractor on contract from the date of certification to
the date of preparation of contract account will be added to get the amount of
uncertified work
8. If material consumed as well as material in hand or at site are given, we can find
out material issued to contract account by adding these two figures. In other
words –Labour Issued = labour consumed + labour in hand or at site
9. In case the contract price is not given in question, then 2/3 of notional profit
should be credited to Profit and Loss A/c.
Format of Contract Account
We added formats of contract account, contractee’s account, balance sheet, and
valuation of closing stock.
Contract Account

Particulars Amount Particulars Amount

To Materials By Materials

(i) Direct Purchases (i) Returned to Suppliers

(ii) Issued from Stores (ii) Returned to Stores

(iii) Transferred from (iii) Transferred to other

other Contracts Contracts

(iv) Sold

To Wages (v) In Hand

To Plant By Plant

(i) Cost of Special Plant (i) Returned to Stores

(ii) Depreciation of (ii) Transferred to other

General Plant Contracts

To Direct Expenses (iii) Sold

To Cost of Sub- (iv) In Hand
contracts

To Cost of Extra Work By Profit and Loss Account

To indirect Expenses (i) Materials Lost, Stolen or

Destroyed

To Expenses Accrued (ii) Plant Lost, Stolen or

Destroyed

By Contractee’s A/c

(Contract Price in case of a

completed contract)

OR

By Work-in-Progress A/c

(i) Value of Certified Work

(ii) Cost of Uncertified Work

(In case of an incomplete

contract)

Contractee’s Account for Contract Costing

 Particulars $ Particulars $

Contract account (value of work xxxx Bank A/C (cash received) Balance xxxxx
certified) x c/d

xxxxx

xxxx xxxxx
x

Balance Sheet for Contract Costing

Liabilities $ $ Assets $ $

Profit & loss: Fixed asset:

Profit on contract xxxx Plant xxxx

x x

(-) Less: loss on fire xxxx xxxx (-)Less depreciation xxxx xxxxx
x x x

Outstanding Liabilities: Other fixed assets

Accrued wages xxxxx (-)Less depreciation    

Accrued direct expense xxxx xxxxx

x

Other accrued expense xxxx Current assets:

 x

xxxx Material at site xxxx

x x

Work-in-progress xxxx
x

Cash in hand xxxx

x

xxxxx

xxxx xxxxx
x

Valuation of closing stock

If realized & unrealized profit can be determined; then:-

Explanation $

Cost of work certified xxxx

(+) Cost of work certified xxxx

= xxxx

(-) cash received xxxx

= xxxx
 (-) provision for unrealized profit work-in- xxxx

Progress

Work in progress = xxxx

If national profit can be determined but realized profit cannot be

determined:-

Explanation $

Cost of work certified xxxxx

(+) Cost of work certified xxxxx

=. xxxxx

(-) cash received xxxxx

= xxxxx

(-) National profit xxxxx

Work in progress = xxxxx

If national profit cannot be determined:-

 Explanation $

Cost of contract xxxxx

(-) cash received xxxxx

Woi;k in progress = xxxxx

Process Costing: Definition, Features →