Key Takeaways:
- Understand the principles and features of contract costing used in large-scale projects.
- Learn how to distinguish between work certified and uncertified, calculate notional profit, and apply cost plus contracts.
- Gain practical skills through a detailed, step-by-step example of contract account preparation and profit calculation.
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Imagine overseeing a construction project where every rupee spent and every brick laid must be accounted for. In such scenarios, Contract Costing becomes a critical tool, allowing firms to monitor costs, manage payments, and assess profitability throughout the project’s lifecycle.
Contract Costing
a. Definition and Features
Contract Costing is a distinct method of cost accounting designed for industries that execute large, unique, and long-term projects, most notably in construction, engineering, and shipbuilding. Each contract is treated as an independent cost unit, with its own ledger to systematically record all direct and indirect expenses. The contractor (who undertakes the work) and the contractee (for whom the work is done) are parties to these agreements.
- Separate tracking: Costs, materials, labor, overheads, are assigned directly to each contract, ensuring precise analysis.
- Long duration: Most contracts span several accounting periods, requiring periodic assessment of costs and revenue recognition.
- Progress billing: Payments are typically received in stages, reflecting the percentage of completion.
- Cost control: Detailed records enable firms to monitor expenditures, compare actuals to budgets, and control overruns.
b. Work Certified vs. Work Uncertified
| Aspect | Work Certified | Work Uncertified |
|---|---|---|
| Definition | Portion of work completed and certified by the contractee’s architect/engineer | Work completed but not yet certified by the contractee |
| Basis for payment | Eligible for progressive payment | No payment until certified |
| Valuation | Valued at contract price | Valued at cost incurred |
This distinction is vital for revenue recognition and profit calculation. Certified work represents value acknowledged by the client, while uncertified work remains an asset in progress.
Notional Profit
a. Concept and Calculation
Notional profit measures the theoretical profit on incomplete contracts at a reporting date. It’s computed as:
Notional Profit = (Value of Work Certified + Value of Work Uncertified + Cash Received) - (Cost Incurred to Date)
Usually, only a portion of notional profit is transferred to the Profit & Loss Account to ensure prudence, considering the contract’s stage of completion. The most common formula for this transfer:
- If work certified < 25% of contract price: No profit transferred.
- If work certified 25%–50%:
Profit transferred = Notional Profit × (1/3) × (Cash Received / Work Certified) - If work certified > 50%:
Profit transferred = Notional Profit × (2/3) × (Cash Received / Work Certified)
This approach protects against recognizing profits prematurely, especially in contracts with significant outstanding work.
Cost Plus Contract
a. Definition and Calculation
Cost plus contract refers to an agreement where the contractor is paid actual costs incurred plus an agreed percentage or fixed fee as profit. This method is common when precise cost estimation is difficult such as projects with uncertain scope or fluctuating input prices.
- Calculation: Total Payment = Actual Cost Incurred + Agreed Percentage of Cost (as profit)
- Ensures the contractor’s risk is minimized and the contractee pays for actual expenditure, plus a reasonable profit.
Example
Let’s work through a practical example to reinforce these concepts.
Contract Account Preparation with Notional Profit Calculation
Scenario: ABC Ltd. undertakes a contract for ₹10,00,000. During the year:
- Materials issued: ₹2,50,000
- Labor paid: ₹3,00,000
- Plant installed: ₹1,00,000
- Direct expenses: ₹50,000
- Materials at site (end): ₹30,000
- Plant depreciation: ₹10,000
- Work certified: ₹6,00,000
- Work uncertified: ₹40,000
- Cash received: ₹4,80,000
Step 1: Calculate total costs incurred.
- Materials used = ₹2,50,000 - ₹30,000 = ₹2,20,000
- Labor = ₹3,00,000
- Plant = ₹1,00,000 - ₹10,000 = ₹90,000
- Direct expenses = ₹50,000
- Total cost to date = ₹2,20,000 + ₹3,00,000 + ₹90,000 + ₹50,000 = ₹6,60,000
Step 2: Prepare the Contract Account.
| Dr. | Cr. | ||
|---|---|---|---|
| To Materials Issued | ₹2,50,000 | By Work Certified | ₹6,00,000 |
| To Labor | ₹3,00,000 | By Work Uncertified | ₹40,000 |
| To Plant Installed | ₹1,00,000 | By Materials at Site | ₹30,000 |
| To Direct Expenses | ₹50,000 | By Plant Depreciation | ₹10,000 |
| By Notional Profit (Balancing Figure) | ₹70,000 | ||
| Total | ₹7,00,000 | Total | ₹7,00,000 |
Step 3: Compute Notional Profit:
Notional Profit = (Work Certified + Work Uncertified + Materials at Site) - Total Cost to Date
= (₹6,00,000 + ₹40,000 + ₹30,000) - ₹6,60,000 = ₹70,000
Step 4: Calculate profit to transfer to P&L Account (Work certified is 60% of contract price):
- Profit transferred = Notional Profit × (2/3) × (Cash Received / Work Certified)
- Cash Received / Work Certified = ₹4,80,000 / ₹6,00,000 = 0.8
- Profit transferred = ₹70,000 × (2/3) × 0.8 = ₹37,333
So, ₹37,333 would be transferred to the Profit & Loss Account this year, reflecting prudent profit recognition based on contract progress.
Contract costing demands both conceptual clarity and computational skill. As you practice, think about How does each entry reflect reality at the project site? What safeguards does the system offer against inflated profits?