Understanding Contract Costing – Definitions | Formulas | FAQs

Table of Contents

1. Introduction
2. Important Definitions
3. Important Formulas
4. 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

1. 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.
2. 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):

1. Estimated Profit × Work Certified/Contract Price
2. Estimated Profit × Work Certified/Contract Price × Cash Received/Work Certified
3. Estimated Profit × Total Cost to date/Estimated Total Cost
4. 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)