UNIVERSITY OF EDUCATION

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.

• A cost plus contract allows for the contractor to be reimbursed for

allowable or defined costs plus a percentage of these costs or a fixed
charge.

• Note that, contracts may contain both features in some instances

Similarities with job costing
• Although they are done away from the enterprise, they share these
similarities with job costing:
1. Undertaken to customers special requirements
2. Takes a relatively loner time to complete
3. They are site based
4. They are mostly of a construction nature
Cost Plus Contract
• A Cost plus contract is used in the case of those contracts whose exact cost
cannot be correctly estimated at the time of undertaking a work.
• The profit to be paid to the contractor may be a fixed amount or it may be a
particular percentage of cost or capital employed.
• These type of contracts are undertaken for production of special articles not
usually manufactured.
• It is generally employed when Government happens to be the contractee.
• The contractor and contractee, in such circumstances will have a clear
agreement about the items of cost to be included, type of material to be
used, labor rates for different grades, normal wastages to be permitted and
the rate or amount of profit.
Advantages of Cost Plus Contracts
• Cost plus contract ensures that a reasonable profit accrues to the
contractor even in risky projects.
• It simplifies the work in offering tenders and quotations.
• It provides escalation clauses and thus covers the contractor from
fluctuations in price and utilization of elements of production.
• The customer is assured of paying only reasonable amount of profit.
• The customer has the right to conduct cost audit so that he can
ensure that he is not being cheated by the contractor.
Disadvantages
• Since the contractor is assured of a profit margin, he may not take
initiative for cost reduction by affecting economies of production and
reducing wastages.
• The ultimate price to be paid by the customer cannot be exactly
ascertained until the work is completed and this creates delay in billing
the customer.

• 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

• Value of work certified to date – cost of work to date

• The profit taken to the income statement is based on an agreed level
of work completed.
Determining profit
• Cost of work to date * 100%
Contract cost

This is always stated in %

• When cost of work to date is not given in the question, the formula
below is used
Value of work certified * 100%
Contract price

• Value of work certified = cost of work certified + profit

• Although the degree of work completed is used in determining profit, the
following must be adhered to:
1. If degree of completion is less than 35%, no profit should be taken
2. If degree of completion is between 35% and 85% the profit to take to the
income statement is computed as:
2 * surplus * Proportion of Cash Received
3 Value of Work certified
• The profit or surplus not taken is termed profit in suspense.
3. If degree of completion is greater than 85%, all profit for the period is
recognized in the income statement
Note the following
1. In the income statement, cost of sales and sales figure will not change if all
profit is taken. Thus, gross profit does not change.
2. If proportion of profit is taken (say when work is between 35% and 85%), the
sales and cost of sales figure is reduced by the factor
2 * proportion of cash received
3 value of work certified
3. Cash received = amount paid by client less retention fees
4. Value of work certified = sales
5. Cost of work certified = cost of sales
6. Cost of work not certified = W.I.P
THE CONTRACTEE ACCOUNT
• This is the personal account of the client or customer.
• It is debited with the value of work certified and credited with
progress payment (payment on account).
• Retention fees are not considered as debt at this stage and therefore
do not appear as debtors in the statement of financial position.
• A note could be made to state the amount of retention fees. Progress
payments are used in computing W.I.P.
Items to appear in the SOFP
• All carried down amounts in the current section which have brought
to the future section should appear in the statement of financial
position

• The W.I.P should also be indicated in the statement of financial

position. However, the items used in computing the W.I.P balance
should not be shown
• There two ways of computing WIP
WIP CONTRACT ACCOUNT METHOD
Cost of work to date:
Cost of work certified xx
Cost of work not certified xx
xx
Add: profit taken xx
xx
Less: cash received xx
W.I.P XXX
WIP CONTRACTEE ACCOUNT METHOD
Cost of work not certified xx
Add: balance on contractee account xx
xxx
Less: profit or surplus in suspense xx
W.I.P XXX
 FORMAT OF A CONTRACT ACCOUNT
GHOSH AND GUSSY CONSTRUCTION LTD
CONTRACT ACCOUNT
K.VI.P AB 24
GHS GHS
Materials purchased X Materials to store X
Materials issued from store X Materials c/d X
Direct wages x Plant c/d X
Add: Accrued wages x X  
Expenses X Cost of work to date:
Depreciation (rate given) X Cost of work certified x
Insurance x Cost of work not certified x X
Less: Prepayment x X  
Plant b/d X  
XX XX
 

Cost of work certified X Value of work certified X

Profit:  
Profit to P&L a/c x  
Profit in suspense (c/d) x X  
XX XX

Materials b/d X Wages accrued b/d X

Plant b/d X Profit in suspense b/d X
Insurance prepaid c/d X  
Cost of work not certified X  
XX XX
End of slides
Refer to chapter 9 of main text for solved questions