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WINNEBA
SCHOOL OF BUSINESS
DEPARTMENT OF ACCOUNTING
COST ACCOUNTING LECTURE
SLIDES
BBAD 246
CONTRACT COSTING
I. A. AHMED
Introduction
• Contract costing applies the principles of job order costing.
• In contract costing, each contract is treated as a cost unit and costs are
ascertained separately for each contract.
• It is suitable for business concerns such as construction, engineering
projects, building or structural projects.
• The International Accounting Standard (IAS 11) makes provision for
contract costing and describes accounting issues pertaining to
contracts.
• The standard describes the accounting treatment for revenue and costs
associated with construction contracts
Definition
• A construction contract is defined by the standard as a contract
specifically negotiated for the construction of an asset or a group of
interrelated assets.
• Two types of contracts are identified.
• These are fixed price contract and cost plus contract.
Fixed Price Contract & Cost Plus Contract
• A fixed price contract is subject to some escalation clauses, even
though the contractor agrees to a fixed price or a fixed rate per
output produced.
• The customer has to pay not only the resultant high cost but also the
resultant high profit. Thus, the customer has to pay substantially for lack
of proper attitude (towards cost and efficiency) on the part of contractor
Features of Contract Costing
1. High proportion of direct cost:
• Materials ordered specifically for the contract or drawn from the main
store per material requisition are charged to the job
• All labor costs are treated as direct even it is a type of labor which is
generally regarded as indirect e.g. night watchman and site clerks
salaries
• All expenses are direct. This is because of the self-contained nature of
most site. For instance, the site may have its own telephone,
electricity and pay for insurance. These are directly charged to the
contract even though they are indirect expenses
Features (contd)
2. Contract plant and equipment
• If plant is leased or hired for the job, the leasing costs are directly
charged to the contract
• If plant is purchased:
• A depreciation charge is made to the job using the rate
• The cost of the plant is first charged to the job. The plant is valued at
the end of the contract period and credited to the job. The difference
is what is charged to the job (depreciation)
Features (contd)
3. All expenses accrued and prepaid are treated as in financial
accounting
4. Due to the long term nature, scale and size of many contracts;
• It becomes necessary form periodic valuation to be made of the work
done for progress payment
• The customer will most likely withhold payment of a portion of the
contract value for any future construction defects. These monies are
called retention fees or monies. They are only payable after all defects
have been rectified or the warranty period given by the contractor
has expired.
Features (contd)
5. For the sake of prudency, not all profits earned on the contract to
date are taken as profits for the period to the income statement
account. A portion of the profit is reserved for unforeseen
circumstances. Losses however, in relation to the same principle are to
be written off in full to the income statement.
Features (contd)
6. Extras:
Where some additional work not stipulated in the contract is carried
out, the expenditure on this additional work should be separately
analyzed from that which is charged to the main contract. If the
additional work is quite substantial, it should be treated as a separate
contract and a separate account should be opened for it. If it is not very
substantial, expenses incurred up on extra work should appear on the
debit side of the contract account as ‘cost of extra work’, and the extra
amount which the contractee has agreed to pay should be added to the
contract price.
Features (contd)
7. Sub-contracts:
Generally, work of a specialized character e.g. the installation of lifts,
special flooring etc. is entrusted to other contractors by the main
contractor. The cost of such sub-contracts is a direct charge against the
contract for which the work has been done.
Features (contd)
8. Escalation clause:
Escalation clause is usually provided in the contract as a safeguard
against any likely changes in the price or utilization of material and/or
labor. This clause provides that in case prices of items of raw materials,
labor etc. specified in the contract change during the execution of the
contract, beyond a specified limit over the prices prevailing at the time of
signing the agreement, the contract price will be suitably adjusted. The
terms of the contract specify the procedure for calculating such
adjustment in order to avoid all future disputes. Thus, this clause
safeguards the interest of both the contractor and the contractee in case
of fluctuations in the prices of material, labor etc.
Accounting for contracts
• Two accounts are used in accounting for contract cost.
• These are the
1. Contract account and
2. Contractee account.
THE CONTRACT ACCOUNT
• This account is used in determining the cost and also the profit or loss
on the contract up to a certain period.
• Different contract accounts are kept for different contracts.
• Presumably, the account is divided into three sections.
• These are:
1. The cost/current section
2. The profit/loss section and
3. The future section.
The cost/current section
• It accumulates all costs relating to the job or contract.
• These costs are debited in the contract account.
• In this section also, the cost of work to date is determined.
• The cost of work to date helps to determine sales.
• Cost of work to date is classified as:
1. Cost of work certified = cost of goods sold
2. Cost of work not certified = work in progress
The profit section
• In this section, the cost of goods sold is brought down.
• At this stage or section, the contract account is credited with the
value of work certified (sales).
• Profit is determined in this section.
• As indicated earlier, not all profit is taken for the sake of prudency.
The future section
• It records all unexpired items per the contract.
• These unexpired items include; prepayments, materials on site, unexpired
revenues, accruals etc.
• Note that, materials return to store and materials on site are not the same.
• Materials returned to store are added back to inventory.
• Thus they increase the value of inventory in store.
• Materials on site are those materials which have not been utilized on the
currently but are most likely to be used at a latter period.
• Materials retuned to store should therefore not be included in this section.
Determining Profit
The following procedures are useful for profit determination
1. Determine overall contract profit as follows:
• Contract price less contract cost
• Contract cost = cost of work to date + Estimated cost of work to
completion
• Contract price is derived from quotation cost or price
2. When losses are made, they are written off entirely to the period
they relate. This should be done with immediacy.
Determining profit
3. When there is profit (surplus or notional profit or apparent profit) on
the overall contract (per the step in 1 above), there will be a need to
determine the period profit or profit for the period to be taken. This
profit is recorded in the Income Statement of the entity. The surplus is
given as