Contract costing is a costing technique which is applied in accumulating the cost of large scale jobs. It is also called terminal costing.
Characteristics of contract costing
There is a high proportion of direct cost since almost all the cost incurred arise due to the particular work being done.
The contract may continue for more than one accounting period leading to technicalities in profit recognition
The contract price is normally estimated in advance of the work
The work is executed in the premises of the contractee
The work to be executed depends upon customer specification. Hence very rarely two contracts resemble one another
Progress payments are made depending on the stage of completion of the work
Each contract is treated as a cost unit
Similarities between contract costing and job costing
Production starts on received orders from customers
Every job and contract is dissimilar in nature
There is no need to create demand since customers come on their own
Profit is determined on each job or each contract separately
Work is to be executed according to the customer‟s specifications
They belong to the category of specific order costing
Differences between contract costing and job costing
A job is small in size whereas a contract is big in size
Work under job costing is performed in the premises of the manufacturer. In contract costing, the work is done in the premises of the customer
A job usually takes less time to complete compared to a contract
The sales value of a job is paid after the job is completed fully. Under contract costing, progress payments are made depending on which stage the work has reached
Expenses under job costing take the form of direct and indirect whereas under contract costing, most of the expenses are direct in nature
Profit earned on a job is entirely taken to the profit and loss account whereas for incomplete contracts, only a portion of the profit is taken to the profit and loss account
1. Retention money
As the contract work progresses, the consultants appointed the contractee issues certificates to indicate the portion of the work already completed. The contractor will be paid according to this certificate and a certain portion thereof will be retained the contractee. This is called retention money.
2. Notional profit
This is the difference between the value of work certified and the cost of work certified.
The contractor may entrust certain types of specialized work such as electrical, plumbing, painting, carpentry, special flooring etc to a sub-contractor. The sub- contractor is responsible to the main contractor in terms of performing the work and he gets his payment from the main contractor. The cost of sub-contracts is debited to the contract account.
Profit on incomplete contracts
Many contracts take more than one accounting year. A problem arises as to whether profits on such contracts should be recognized only on their completion or whether some profits should be recognized every year.
The general position is that profit should be recognized in respect of work certified only.
The degree of completion
This is determined using any of the following formulae:
For purposes of recognizing profit on incomplete contract, the following general rules may be applied. However, a company may have its own unique policy regarding the treatment of profit on incomplete contracts:
1. For contracts which are less than quarter-way complete, no profit should be computed and credited to the profit and loss account
2. For contracts which are complete between 25%-50%, a
1 of the notional profit
reduced in the ratio of cash received to value of work certified is transferred to the profit and loss account
(a) Prepare the contract account
(b) Prepare the contractee account
(c) Compute the contract’s profit to be taken in the Company’s Profit and Loss Account explaining with reasons why you have used the computation method you have adopted.
It is prudent to transfer all losses to the profit and loss account
Big Ones Ltd. has undertaken to perform a contract for Small Things Ltd. The contract started on 1 April 2010. Costs to 31 December 2010, Big Ones Ltd‟s year end, can be ascertained from the following information.
As at 31 December 2010, certificates had been issued for work valued at ksh. 60,000 and Small Things Ltd had made progress payments of ksh.53,000. Big Ones Ltd has calculated that they have performed more work since the last certificate was issued, the cost of this work done but not yet certified being ksh.10,000.
The contract is 80% complete and so Big Ones Ltd takes three quarters of notional profit to the profit and loss account as the profit earned on the contract for the nine months to 31 December 2010.
(a) Draw up a contract account for the nine months to 31 December 2010 or the contract Big Ones Ltd is performing for Small Things Ltd.
(b) Calculate the profit attributable to the contract to be included in the profit and loss account for the year ended 31 December 2010.
(c) Calculate the turnover to be included in the profit and loss account for the year ended 31 December 2010.
(d) Calculate the cost of sales to be included in the profit and loss account for the year ended 31 December 2010.