CONTRACT COSTING

This is a form of specific order costing that is used by firms of builders and public works contractors who under take work on the contract basis. This costing method is applied to work which:

  1. Is undertake to meet customers specific requirement. This means that the construction is undertaken following the customers expectation.
  2. Takes a considerable long time to complete. Construction work is not normally done and completed in a week, month and not even in a year depending on what is under construction. Complex building can even take more than five years.
  3. The construction work or the processing of the product is always done away from the firm’s premises. This implies that the construction work is site based.
  4. Is frequently of construction nature such as road construction, dam construction, construction of building and ship construction.

IAS 11 – Accounting for construction contractor defines a construction contract as “ a contract for the construction of an asset or a combination of  asset which together constitute a single project”. Example of activity  covered by such contracts include the construction of bridges, dams, ships, building and complex pieces of equipment and oil exploration contracts. The contract price is normally estimated in advance of the work. Additional work found necessary may be charged on a cost-plus basis. In addition, clause may be inserted to allow the contractor to pass on the customer additional cost incurred as a result of increase in material, labour and other cost.

Payment by the number for various staged of the contract is made only on receipt of architect’s certificate for the completed stage. A reduction called retention money is withheld by the customer until a specific period of time, agreed in the original contract, has passed.

A contract account is opened for every individual contract and record all the costs incurred in carrying the contract work. All material purchased from suppliers or got from the ware house is debited to the contract account. Sometimes material can be scraped and sold, the scrap sales are shown on the credit side of contract of the contract account. Materials destroyed by fire or stolen are credited to profit and loss account.

 Contract or Terminal costing is seen also as the system employed by firms which devote all energies to one or two, big contracts in a year.   Contract costing applies where a form contract is made between the customer and supplier.  The work is usually undertaken customers’ special requirements, of long duration and constructional in nature, Building           and construction work, civil engineering and ship building.

This is another form of job costing as jobs are done to owners’ specifications or requirements. The difference being that the job is completed over a longer period of time and in most cases it is carried out on the site or premises of the contract employer or owner. Also contracts are of the nature of construction or civil engineering that usually involve huge sums of money.

All materials, plant and equipment, vehicles, utilities (e.g. electricity, telephone etc.) bought or transferred to a contract constitute the direct costs. Administration costs, a proportion of Head Office expenses and joint costs shared by other on-going contracts of the organization constitute indirect costs. A contract account is opened for each ‘ contract to determine its profit or loss with all costs, direct or indirect debited.

Due to the long duration and heavy cost of most contracts, progress payments are made to the contractor on the basis of work certified by architects or engineers. On completion of the contract, a percentage of the contract value is retained as rectification cost or retention fee by the contractee. The money, a kind of quality guarantee deposit is paid back to the contractor if no material defect is found on the job, say six months after completion.

Where a contract is started and completed in a single accounting period, the profit or loss on the contract is the difference between:

“The contract price, materials c/d, materials returned from site, plant and machinery c/d on the credit side and all direct costs, including sub-contracts and indirect costs on the debit side.”

Where the contract extends beyond one accounting year, the profit to be transferred to the company’s profit & loss account will be considered

FEATURES OF CONTRACT COSTING

  1. A formal contract is made between the customer and the supplier.
  2. Work is undertaken to customer’s special requirements.
  3. The work is for relatively long duration.
  4. The work is frequently constructional in nature.
  5. The method of costing is similar to job costing
  6. The job frequently base on size
  7. Retention money may be deducted from progress payment.
  8. A contract includes clauses for penalty for delayed completion and bonus for early completion.
  9. Payments on account are often made against work certified.

PROBLEMS WHICH MAY ARISE IN CONTRACT COSTING

  1. Problem of identifying direct cost:- Due to the large size of the job, many cost items which are usually regarded as production overhead are charged as direct cost of the contract e.g. hire of plant, supervision, sub-contractor’s fees or charges, telephone installed in the site etc.

2.   Problem of low indirect cost:-In view of many costs usually classified as overhead being charged as direct cost of the contract, the absorption rate for overhead should only apply to cost items which are not already direct cost e.g. head office expenses.

3.   Difficulty of cost control:-Because of the scale of contract and size of sites, there are often cost control problems e.g.

(a)   Material usage and losses – theft or pilferage.

(b)   Labor utilization and supervision.

(c)   Damage to and loss of plant and tools.

(d)   Unexpected cost involving rectification cost, penalties for late completion, etc.

4. Problem of dividing profit between different account period:- How to divide profit between the periods particularly when a contract cover two or more accounting periods is a problem.                      

TERMINOLOGIES in contract costing

  1. Contract price:- This refers to a price of the contract as may be agreed between the contractor and the contract. The price is usually binding until the work done is certified.
  2. Progress payment:- The contract normally provides for the client to make payment either at specific stages of the work e.g. when foundation is completed, or first floor completion or at particular agreed interval. The basis for this interim payment is an architect certificate of work satisfactorily completed.
  3. Architect certificate:- This is a certificate issued by experts certifying the work or any

portion of the work satisfactorily completed. It shows the work done at selling price (market value), and this certificate accompanies the invoice sent to the customer. The amount paid is normally the certified value less the % retention which is released when the contract is fully completed and accepted by the customer.

  • Retention fee:- This is the amount agreed to be withheld by the contract at the end of the contract, and which will be released to the contractor after the agreed period. It serves as a guarantee against any bad work or unexpected damage due to imperfect job by contractor.
  • Estimated profit:- This is the difference between the contract price and the estimated cost of the contract.
  • Cost-to-date:- This represents the total cost incurred to date on the contract It is obtained by adding all cost incurred to date.
  • Work certified:- It is always necessary that at every point of the contract, an expert has to be called in by the contract to certify that such portion performed by the contractor has been properly performed and according to schedule. Any uncertified portion is known as work not yet certified e.g. 60% completed, 10% uncertified: 50% certified plus 10% not yet certified.
  • Cost of work certified:- This is the total cost incurred on the portion certified. It is the cost to date minus cost of work not yet certified.
  • Value of work certified:- This is the market value of work certified as may be determined by the cost accountant.
  • Notional profit or loss:- This is the profit earned on the contract to date. It is calculated as the difference between the value of work certified to date and the cost of work certified to date.

1.            Where the contract has just started

2.            Where the contract is reasonably advanced but is stili difficult to estimate cost necessary to    complete.

3.            Where contract is nearing completion and cost necessary to complete can be easily estimated.

1.         Where contract has just started

It is generally recommended that no profit should be taken on the contract at this stage. But if, however, any loss is ascertained from the contract account, it should be charged in full to profit & loss account. This is in line with the convention of conservatism which forbids the anticipation of profits.

2 .If  the Contract  is Fairly Advanced

At this level only a proportion of the apparent profit on the contract to date is taken. The proportion taken vary among companies. Most firms take 2/3 or 3/4 but for the purpose of this book, 2/3 is recommended, and the profit taken is calculated as:

Cash Received

  1. 2/3 x Apparent profit         x    value of work certified

Where: Apparent (Notional) profit is;

Value of work certified                                                          

Less: Cost of work to date                                                                  

Less: Cost of work not yet Certified                           

Apparent profit                              

3.        When the contract is nearing completion

Where the contract is close to completion with say over 80% of total work done, and it is easy to estimate with reasonable certainty cost necessary to complete. The estimated contract profit is obtained by deducting from the contract price the cost to date plus estimated cost necessary to complete, provision for contingencies, including rectification cost. The profit is further reduced by the formula.

Cost of work completed

  Estimated  profit        Total cost on completion

Any profit that has been taken in previous years will be deducted to get the profit to be credited to the current year profit and loss account.

All labour employed at the contract side should be regarded as direct labour and charged direct to the contract concerned as debited entries. Wages accrued or outstanding at the end of the period should appear on the debit side of the contract account. All direct expense other than material and labour are charged to individual contract as and when they incurred e.g sub-contractor charges. The contract account is shown figure  below

CONTRACT ACCOUNT

                                             Contract Account Number………….

UGX                                                    NAIRA                                                            NAIRA

Material costs                                       xxxx                  Un-used material                   xxxx

Labour costs                                        xxxx                  Book value of plant               xxxx

Overhead costs                                                xxxx                  Work certified                                   xxxx

Sub- contract charges                           xxxx                   Uncertified work                  xxxx

Plant cost                                             xxxx                Other costs                               xxxx

Notional profit                                    

To P&L account                                  xxxxx                 Notional profit b/d                xxxxx 

To Reserve account                             xxxxx 

Work in progress includes the amount of work certified (valued at contract price) and the amount of work uncertified. The work in progress will appear in the balance sheet as a current asset. It is computed as follows:                                                                    

NAIRA

Work in progress:                                                       

Cost incurred to date                                                    xxxxx

Profit (loss)                                                                  xxxxx

                                                                                    Xxxxx

Less: Invoiced amount                                                 xxxxx

Work – in progress                                                      xxxxxx

Profit on incomplete contracts:

The principal problem relating to accounting for construction contract is the allocation of revenues and related costs to accounting periods over the duration of the contracts.

Some contract may take more than one year and hence not matching the accounting year. A problem arises whether profit on such contract should be worked out only on its completion or whether some profits may be computed every year. In this case, the manner of computation of profit is largely dependent upon how far the contract has advanced that is, the stage of completion it has reached.

The principle established in IAS 11 is that profit can be recognized once the outcome of a contract can be reliably as profitably. Such contract should be assessed on a contract by contract basis and reflected in the income statement by recording revenue and related costs as contract activity progresses.

Contract revenue is ascertained in a manner appropriate to the stage of completion of the contract, the business and the industry in which is operates.

Where it is considered that the outcome of  a construction contract can be assessed with reasonable certainty before its conclusion, the  prudently, calculated attributed profit should be recognized in the income statement as  the different between the reported and related cost for  that contract.

If the expected outcome is a profit, revenue/ expense will be recognized according to the completion of that contract. Under this method contract revenue, is matched, with the contract cost incurred is reaching the  stage of comp99letion, resulting in the reporting of revenue, expenses and profit proportion of work done.

The standard does not specify the method of determining percentage of completion, but it may be arrived at using the following formulae.

Either:              Percentage of completion = Certified work

                                                                   Contract price/revenue

Or                    Percentage of completion =      Cost to date    

                                                                    Total estimated contract cost

ILLUSTRATION 1

Roko Construction Company is engaged in a number of long- term contract. The following details relate to the three uncompleted contracts in the company’s books at 31 December 2015.

Contract Number                                 021                       022                  023

                                                            N                            N                    N

Cost of work to 31st Dec. 2015                        1,218,000        1,091,200          545,600

All certified

Value of work to 31st Dec. 2015                     1,540,000          880,000              72,000

Progress payment made                                   1,320,000          704,000            440,000

Progress payment received                  1,100,000          704,000            440,000

Estimate of full cost + future cost        1,320,000          1,540,000      2,640,000

Final contract price                              1,672,000         1,232,000      3,520,000

Note: The cost of work to 31st December 2015 has been determined after crediting unused material and the written down value of plant use.

Required;

  1. Prepare a statement for the managing director showing your calculation for each contract of the valuation of work in progress at 31st December 2015, and the net profit (loss) included therein.
  2. Show as an extract the information which should appear in the Balance sheet for the work in progress.

Solution:

Contract No.                            021                  022                  023

Degree of completion:            

= Value of work certified        1,540,000        880,000           572,000

Contract price                          1,672,000        1,232,000        3,520,000

                                                92%                 71%                 16%

                  ROKO CONSTRUCTION CONTRACT STATEMENT

Contract N0.                                        021                  022                  023

                                                            N                     N                     N

Contract price                                      1,672,000        1,232,000        3,520,000

Estimated total cost to

Completion                                          1,230,000        1,540,000        2,640,000

Attributable profit/loss                       352,000           (308,000)         880,000

Valuation of work in progress:

Cost incurred to date                            1,218,000        1,091,200        545,600                       2,854,800

Profit (loss)                                             323,840        (308,000)         ———–          15,840

                                                          1,541,840             783,200                    545,600                       2,870,640

Work in progress for balance sheet

WIP to date                                          1,541,840        783,200                       545,600                       2,870,640

Less invoiced amount                          1,320,000        704,000           440,00                         2,464,000

                                                            221,840           79,200             105,600                       406,640

Notes:

  1. Contract No. 021

The profit of  N 352,000 should be recognized since the contract has already reached advanced stage.

  • Contract NO. 022

Has a for seeable loss of N308,000 which is to be charged in full against profit and loss account for the year.

  • Contract NO. 23

Has not advanced since its degree of completion of 16% is less than the recommended 25%. NO profit is to be recognized in this contract.

The following particulars relate to a contract undertaken by Roko construction

ILLUSTRATION 2

Chuks  Construction Ltd. worked on two major contracts during a financial period. The contracts Nos. 25 1 and 252 were at various stages of

Completion and other details were as follows:

                                     CONTRACT

            No. 251 No. 252
  N’000 N’000
Contract price 90,000 150,000
Total cost to date 27,200 95,450
Estimated cost to completion 37,600 15,500
Contingencies 50
Value of work certified 37,800 129,000
Cost of work not yet certified 4,700 9,600
Cash received 32,000 125,000
Rectification cost 2,000
Profit earlier taken 16,800

Required:

Calculate the profit to be taken to the years profit and loss account in respect of contract Nos. 251 and 252.

To be able calculate profit to be taken, first estimate the level of completion for each contract. Estimated level of completion =

                              Cost to date X                100

                                            Total cost to completion

                                                N27,200,000 x 100

Contract No. 251         =          N64,800,000

                                    =          42%

                                                N95,450,000 x 100

            Contract No. 252         =               N111,002,000

                                                =          86%

At 42% and 86% levels of completion contract Nos. 251 and 252 can be respectively said to be fairly advanced and nearing completion. Therefore profit to be taken can be calculated as.

Contract No. 251

N’000                                   N’000

Value of work certified                                                                                  37,800

Less: cost to date                                 27,200

Less: cost of work not yet certified      4,700   22,500

Apparent profit                                                                                N 15,300

Profit taken = 2/3 x Apparent Profit x

Cash Received value of work             certified Nl5,300,000N32,000,00037,800,000

Contract No. 252

N ‘ 000                                N ‘000

Contract price                                                                                         150,000

Less: Cost to date                                                          95,450

Estimated cost to complete                                          15,500

Contingencies                                                                          50

Rectification cost                                                           2                     111,002

Estimated contract profit                                                                      N38,998

Profit taken =

  • cost of work completed    x       Estimated profit

Total cost on completion         

= N 95,450,000 x N38,998,000

            111,002,000

              = N 33,534,162

N’000

Profit taken to date                                                                  33,534

Less: profit earlier taken                                              16,800

Profit taken this year                                                       16.734

The company’s profit and loss account for the year will be credited with N8,634,921 for contract No. 251 and N16,734,000 for contract No. 252 as profit taken.