Unit - 3
Contract costing
Q1) Explain construction financial management.
A1) Engineering management is a specialized form of management concerned with the application in engineering, as a result of the unique personalities and technical nature of engineering.
Engineering management refers to the functional management of technical professionals. Example areas of engineering are product development, manufacturing, construction, design engineering, industrial engineering, technology, production, or any other field that employs personnel who perform an engineering function.
Successful engineering managers typically require training and experience in business and engineering. Technically inept managers tend to be deprived of support by their technical team, and non-commercial managers tend to lack commercial acumen to deliver in a market economy. Largely, engineering managers manage engineers who are driven by non-entrepreneurial thinking, thus require the necessary people skills to coach, mentor and motivate technical professionals.
There are two main accounting methods that construction companies use to record revenue and expenses. One is called the completed contract method and the other is called the percentage of completion method.
Completed Contract Method - In the completed contract method, only completed projects are reflected in the income statement. Costs for uncompleted projects are accumulated in an asset account called Work in Progress. The principal advantage of the completed contract method is that reported revenue is based on final results rather than estimates of unperformed work. The major disadvantage is that it does not reflect current performance when the period of the contract extends into more than one accounting period.
Percentage Completion Method - Revenues and gross profit are recognized each period based upon the progress of the construction, i.e., the percentage of completion. To determine the percentage of completion of a project, simply divide actual costs by estimated costs. Calculating the amount of revenue to claim for the year is determined by multiplying the percentage of completion by the contract price
Financial statements provide financial information at a point in time and changes to assets, liabilities and equities covering a certain time. The following makes up a set of traditional financial statements:
- Balance sheet (a statement of financial position at a specific date, including assets, liabilities and equity);
- Income statement (a statement of operations covering a period such as a month, quarter or year, showing revenues, expenses, income taxes, gains/losses, net income/loss);
- Statement of changes in retained earnings (changes in retained earnings from the previous period, adding in net income/loss for the year and deducting dividends);
- Statement of changes in cash flow (changes in cash balances from the previous period, which shows sources and uses of cash); and
- Notes to the financial statements, which provide additional information for users for clarification purposes.
Q2) Explain role of financial management in construction financial management.
A2) In today’s environment, the role of the financial manager in a construction organization is essential to organizational success, and more importantly, is vital to avoiding failure. That may sound extreme, but in many circumstances, competition is so fierce and margins are so thin, reliable financial information and analysis certainly can make the difference between success and failure.
The construction financial manager’s role may vary from company to company, partly because different financial managers have different skills and personalities. The role also varies depending on the size of the company. A construction financial manager’s background often indicates the areas in which the manager will concentrate. For example, a construction financial manager whose background is in construction operations (estimating and project management) initially will concentrate on the proper recording of job costs. A construction financial manager whose background is in public accounting probably will initially emphasize financial reporting and income tax planning. The financial manager should recognize these influencing factors and make efforts to compensate for any deficiencies.
The skills and personalities of the other members of the management team also affect the role of the construction financial manager. The majority of a company’s administrative work can be performed in any department and will be allocated among departments partly based on the skills and personalities of the respective department managers. For example, most construction financial managers feel that cash management is their responsibility. If the other management team members share this feeling, responsibility for cash management probably will be assigned to the finance department. However, if another management team member feels that responsibility for cash management should be shared, some compromise will be made. To a great extent, sharing of responsibilities depends on the skills and personalities of the management team members. Successful financial managers respect the need for compromise in sharing responsibilities.
As already mentioned, the size of the company frequently affects the role of the financial manager, because roles and responsibilities are more specialized in larger companies than in smaller companies. In small companies, responsibilities are assigned to a smaller group of managers and, accordingly, each manager must handle a wider range of responsibilities. For example, the financial manager in a small company with three senior managers (owner, operations manager and finance manager) will typically be responsible for all administrative and financial tasks. The other two senior managers will typically concentrate on marketing, estimating and project management. In larger companies, with responsibilities assigned to a larger group of managers, each manager will be assigned more specialized responsibilities. For example, the financial manager of a large company with several senior managers often has limited responsibility for administrative tasks involving contact with customers and subcontractors. The department with primary responsibility for customer and subcontractor relations (usually the construction operations department) will prefer to be the primary contact in order to minimize the possibility of misunderstandings between the parties. Because there is no one standard set of construction financial manager responsibilities, each financial manager should be alert for areas of responsibility that are not clearly defined in the organization. The financial manager should take the initiative in assuring that all significant responsibilities are assigned.
Q3) Explain contract costing.
A3) Contract costing is a type of job costing in which a contract constitutes a unit of cost. The principles of job costing are applicable to contract costing and embrace the same basic principles of cost ascertainment. It is akin to factory job costing, but varies only in size; and the contract continues for a longer time.
A contractor undertakes a small number of big contracts at a time. For example, builders, civil engineering firms, constructional and mechanical engineering firms etc. adopt this method of costing, also known as terminal costing.
The Terminology of I.C.M.A. Defines Contract Costing as – “that form of specific order costing which applies where work is undertaken to customer’s special requirements and each order is of long duration”.
The Terminology of C.I.M.A. Defines Contract Cost as – “the aggregated costs relative to a single contract designated a cost unit”.
Features
Following are the important features of contract costing:
i) The work is carried out away from contractor’s premises i.e., at the contractee’s work site.
Ii) A contract is usually a big job of long-duration and may continue over more than one accounting period.
Iii) As the contracts are of large size, a contractor usually carries out a small number of contracts in the course of a year.
Iv) Contract work involves too much of risk and uncertainty.
v) A contract undertaken is treated as a cost unit.
Vi) A separate account is prepared for each contract to ascertain profit or loss on each contract.
Vii) Apportionment of profit on contract to different accounting periods is very difficult.
Viii) In case the contract is undertaken of long-duration, a percentage of notional profit depending upon the progress of physical work may be accounted for in each year.
Ix) Most of the materials are specially purchased for each contract.
x) Expenses chargeable to contracts are direct in nature, e.g., electricity, telephone charges, insurance etc.
Xi) Allocation and apportionment of overhead costs is a simple task.
Xii) Specialists sub-contractors may be employed for say, electrical fittings, welding works, glass work, plumbing work etc.
Xiii) Plant and equipment may be purchased or hired for the duration of the contract.
Xiv) Nearly all labour will be direct.
Xv) The payment is received depending on the stage of completion of work.
Xvi) A contract usually includes clause for ‘penalty’ for delayed completion.
Xvii) A contract usually includes ‘Escalation Clause’ under which the contractor is compensated for increase in costs on account of inflation.
Xviii) A percentage of the value of work done is deducted from the progress payment as ‘Retention Money’.
Xix) Most of the items of cost are directly chargeable to individual contracts. Administrative overheads and other common costs are apportioned to several contracts on a suitable basis.
Xx) Payments are made on a running account basis depending upon the progress of work as indicated by the certificate of contractor’s architect/ surveyor.
Xxi) A certain amount of profit is taken at the end of the year on incomplete contracts.
Q4) Explain features of contract costing.
A4) Features
Following are the important features of contract costing:
i) The work is carried out away from contractor’s premises i.e., at the contractee’s work site.
Ii) A contract is usually a big job of long-duration and may continue over more than one accounting period.
Iii) As the contracts are of large size, a contractor usually carries out a small number of contracts in the course of a year.
Iv) Contract work involves too much of risk and uncertainty.
v) A contract undertaken is treated as a cost unit.
Vi) A separate account is prepared for each contract to ascertain profit or loss on each contract.
Vii) Apportionment of profit on contract to different accounting periods is very difficult.
Viii) In case the contract is undertaken of long-duration, a percentage of notional profit depending upon the progress of physical work may be accounted for in each year.
Ix) Most of the materials are specially purchased for each contract.
x) Expenses chargeable to contracts are direct in nature, e.g., electricity, telephone charges, insurance etc.
Xi) Allocation and apportionment of overhead costs is a simple task.
Xii) Specialists sub-contractors may be employed for say, electrical fittings, welding works, glass work, plumbing work etc.
Xiii) Plant and equipment may be purchased or hired for the duration of the contract.
Xiv) Nearly all labour will be direct.
Xv) The payment is received depending on the stage of completion of work.
Xvi) A contract usually includes clause for ‘penalty’ for delayed completion.
Xvii) A contract usually includes ‘Escalation Clause’ under which the contractor is compensated for increase in costs on account of inflation.
Xviii) A percentage of the value of work done is deducted from the progress payment as ‘Retention Money’.
Xix) Most of the items of cost are directly chargeable to individual contracts. Administrative overheads and other common costs are apportioned to several contracts on a suitable basis.
Xx) Payments are made on a running account basis depending upon the progress of work as indicated by the certificate of contractor’s architect/ surveyor.
Xxi) A certain amount of profit is taken at the end of the year on incomplete contracts.
Q5) Explain type of contract.
A5) There are two types of contracts:
(i) Fixed price contract and
(ii) Cost-plus contract
(i) Fixed-Price Contract:
In this type of contract, price is usually fixed and agreed upon in advance. Generally, tenders are invited giving details of the contract to fix up the contract price. As per agreement between the parties, any additional work may be charged separately. There may be a provision in the agreement to allow the contractor to pass to the contractee additional costs incurred due to price rise of materials or wages awards, etc.
(ii) Cost-Plus Contract:
Cost-plus contract is a contract in which price is not agreed upon in advance for one reason or other. This type of contract is entered into when it is impossible to calculate future price or cost with reasonable accuracy because of lack of past records and experience or because of peculiar circumstances, for example, drilling of oil well.
The contract price is ascertained later by adding a fixed percentage of profit to the total cost of the contract. Different items of expenditure to be considered for ascertaining cost of the contract are agreed upon in advance.
Advantages of Cost-Plus Contract:
For the Contractor:
(1) The contractor is assured of a fixed profit margin.
(2) There is no chance of incurring any loss on the contract.
(3) The contractor is not affected by any fluctuations in the market prices of different elements of cost.
(4) Submission of tenders becomes simple.
For the Contractee:
(1) The contractee feels satisfied because the price is based on actual cost.
(2) In an uncertain situation, the contractee is completely protected.
Disadvantages of Cost-Plus Contract:
For the Contractor:
(1) It discourages contractor to take measures for cost reduction because the profit is based on cost. Lower cost will lead to lower profit.
(2) Disputes may arise between the parties.
For the Contractee:
(1) Generally, profit is based on cost. It encourages wasteful expenditure since the higher the cost, the larger will be the profit.
(2) The amount to be paid by the contractee is uncertain because it cannot be determined until the work is completed. It may create certain problems in cash management.
Contract costing procedure
The basic procedure for costing of contracts is as follows:
1. Contract Account:
Each contract is given a distinguishing number and a separate account is opened for each contract.
2. Direct Costs:
Most of the costs of a contract can be allocated direct to contract. All such direct costs are debited to the contract account.
Direct costs for contracts include:
i. Materials,
Ii. Labour and supervision,
Iii. Direct expenses,
Iv. Depreciation of plant and machinery,
v. Subcontract costs.
3. Indirect Costs:
Contract account is also debited with overheads which tend to be small in relation to direct costs. Such costs are often absorbed on some arbitrary basis as a percentage on prime cost, materials, wages etc. Overheads are normally restricted to head office and storage costs.
4. Transfer of Materials or Plant:
When materials, plant or other items are transferred from the contract, the contract account is credited by that amount.
5. Contract Price:
The contract account is also credited with the contract price. However, when contract is not complete at the end of the financial year, the contract account is credited with the value of work-in-progress as on that date.
6. Profit or Loss on Contract:
The balance of contract account represents profit or loss which is transferred to Profit and Loss Account. However, when contract is not completed within the financial year, only a part of the profit arrived at is taken into account and remaining profit is kept as reserve to meet any contingent loss on the incomplete portion of the contract.
Q6) Explain contract costing procedure.
A6) The basic procedure for costing of contracts is as follows:
1. Contract Account:
Each contract is given a distinguishing number and a separate account is opened for each contract.
2. Direct Costs:
Most of the costs of a contract can be allocated direct to contract. All such direct costs are debited to the contract account.
Direct costs for contracts include:
i. Materials,
Ii. Labour and supervision,
Iii. Direct expenses,
Iv. Depreciation of plant and machinery,
v. Subcontract costs.
3. Indirect Costs:
Contract account is also debited with overheads which tend to be small in relation to direct costs. Such costs are often absorbed on some arbitrary basis as a percentage on prime cost, materials, wages etc. Overheads are normally restricted to head office and storage costs.
4. Transfer of Materials or Plant:
When materials, plant or other items are transferred from the contract, the contract account is credited by that amount.
5. Contract Price:
The contract account is also credited with the contract price. However, when contract is not complete at the end of the financial year, the contract account is credited with the value of work-in-progress as on that date.
6. Profit or Loss on Contract:
The balance of contract account represents profit or loss which is transferred to Profit and Loss Account. However, when contract is not completed within the financial year, only a part of the profit arrived at is taken into account and remaining profit is kept as reserve to meet any contingent loss on the incomplete portion of the contract.
Q7) Explain format of contract account.
A7) When a contractor has accepted a contract, a separate account is opened for each contract, bringing together all the costs relating to a particular contract. A serial number is assigned to each contract, which is known as a contract account.
Explanation
All expenses incurred in fulfilling a contract (e.g., materials, wages, direct expenses, cost of sub-contracts, cost of special plants, and indirect expenses) are debited to a contract account.
Similarly, expenses accrued or outstanding on the contract at the end of the accounting period are also debited to the contract account. At the end of the accounting period, the following will appear on the credit side of the account:
- Materials returned to the supplier
- Materials and plant returned to store
- Materials transferred to other contracts, stolen, destroyed, sold, or in hand
Materials and plant stolen or destroyed are abnormal losses and should be charged to the profit and loss account.
Similarly, profit or loss arising from the sale of the plant or materials should also be transferred to the profit and loss account by way of abnormal items.
The other items to be shown on the credit side of the contract account are contract price (in completed contracts) and the work-in-progress, which consists of the value of certified work and the cost of uncertified work (in incomplete contracts).
Format
Q8) Explain treatment of various items in the contract account.
A8) Treatment of 14 various items in the contract account
- Cost of Materials - Materials include (i) materials specifically purchased for the contract; (ii) materials issued from store against material requisition notes. The cost of both these types of materials is debited to the contract account.
Materials returned to store. Whenever materials are issued in excess of requirements, as for instance, cement, sand, pipes, bricks, etc., these are later returned to the store accompanied by a Material Return Note which gives the details of the material returned. Such returned materials are credited to contract account.
Materials at site. At the end of each accounting period, value of materials lying unused at site is credited to contract account and is carried forward for charging against the next period.
2. Cost of Labour - All wages of workers engaged on a particular contract are charged direct to the contract irrespective of the type of work they perform. When several contracts are running at different locations, payroll is normally sectionalised so as to have separate payroll for each contract. Difficulties in costing may be encountered when some workers may have to move from one site to another when a number of small contracts are undertaken. In such situation, it becomes necessary to provide time sheets from which allocations can be made. In order to control labour utilisation and prevent fraud in the payment of wages, surprise visits by head office personnel will be necessary.
3. Plant Depreciation - There are two different methods of dealing with depreciation of plant in contract account:
(a) Contract account is debited with the cost of the plant installed. At the end of the year or when the plant is no longer required, the plant is revalued and contract account is credited with this revalued or depreciated figure. In case plant is sold on the completion of the contract, the contract account is credited with its sale proceeds. The net effect of the above debit and credit will be that the contract account will stand debited with the amount of depreciation which is the difference between the value of plant debited and value of plant credited. The method is generally used on long contracts which extend over more than one year because depreciated value of the plant is credited to the contract account and brought down as an opening balance in the next period. (b) Alternatively, contract account is simply debited with the amount of depreciation. It is usual to use this method when plant is sent to contract only for a short period. For example, mobile crane or bulldozer used in a contract may be charged on this basis. However, when a plant is hired for a contract, a charge for the hire of the plant is debited to the contract as a direct expense.
4. Subcontract Costs - Work of specialized character, for which facilities are not internally available, is offered to a subcontractor. For example, steel work, glass work, painting, etc., is usually carried out by the subcontractors who are accountable to the main contractor. The cost of such work is charged to the contract account.
5. Payment based on Architect’s Certificate- In case the contract is small, full payment is usually made on the completion of the contract. But in case of large contracts, it may take more than one year to complete. In such a case, if no payment is received until the completion of the contract, the financial resources of the contractor could surely become strained. Therefore, a system of progress payments is agreed by parties. In this system, part payments of the contract amount are paid from time to time on the basis of certificate issued by the architects (acting for the contractee), certifying the value of the work satisfactorily completed. Such payments received by the contractor are usually credited to the personal account of the contractee. It should be noted that such payments are not entered in the Contract Account.
6. Work-in-progress — Work Certified and Uncertified
When the contract is not completed till the end of the accounting year, the architect is required to value the work-in-progress. Such work-in-progress is classified into work certified and work uncertified.
Work Certified. This is that part of the work-in-progress which has been approved by the contractee’s architect or engineer for payment. Work certified is valued at contract price (i.e., selling price), and includes an element of profit.
Work Uncertified. This is that part of the work-in-progress which is not approved by the architect or engineer. This is valued at cost and thus does not include an element of profit. Both works certified and uncertified appear on the credit side of the contract account and also on the assets side of the balance sheet.
7. Retention Money and Cash Ratio - It is usual practice not to pay the full amount of work certified. The contractee may pay a fixed percentage, say 80% or 90% of the work certified, depending upon the terms of the contract. This is known as Cash Ratio. The balance amount not paid is known as Retention Money. For example, if cash ratio is 75%, the retention money will be remaining 25%. This retention money is a type of security for any defective work which may be found in the contract later on. This also works as a deterrent for the contractor to leave the contract incomplete, if he finds the contract unprofitable. The retention money may also be adjusted against penalties that become due if the contract is not completed within the stipulated time as per the terms of the agreement.
8. Extra Work - Sometimes the contractor is required to do some extra work like additions or alterations in the work originally done as per agreement. The contractor will charge extra money for such extra work. The cost of such extra work is debited to the contract account and extra price realized is credited to the contract account.
9. Contract Price
The contract price is the agreed price at which the contractor undertakes to execute the contract.
The contract account is credited with the contract price if it has been completed. In such a case, the amount of contract price is debited to the contractee’s personal account and credited to the contract account.
In incomplete contracts, no entry is passed in respect of the contract price.
10. Cost of Sub-Contracts
Generally, work of a specialized character (e.g., road construction, installation of lifts, and use of electrical fittings) is passed onto another contractor by the main contractor.
In such cases, the work performed by the sub-contractor forms a direct charge to the contract concerned, and the sub-contract price paid should be debited to the contract account.
11. Indirect Expenses
Some expenses can’t be directly charged to a particular contract, including the salary of the general manager, the salary of an architect engaged at several contracts simultaneously, the salary of a store-keeper, and store and office expenses.
Since these expenses are incurred for the business as a whole, they are to be apportioned to the different contracts on some equitable basis.
12. Direct Expenses
All expenses that have been incurred specifically for a particular contract (other than material cost and direct wages) are direct expenses, and they should be debited to the contract account.
Examples of direct expenses include hire charges of special plant (not owned), carriage on materials purchased, and travel expenses relating to the contract.
13. Site expenses - Any expense incurred on the site shall also be debited. There may be too many expenses under this head. Apply the principle—Debit all expenses and losses.
14. To labour and wages - It’s an expense so it’s shall be debited to the contract account by applying the principle—Debit all expenses. Any outstanding amount shall be added and any prepaid amount shall be subtracted.
Q9) Explain treatment of 10 items in contract account.
A9) Treatment of 14 various items in the contract account
- Cost of Materials - Materials include (i) materials specifically purchased for the contract; (ii) materials issued from store against material requisition notes. The cost of both these types of materials is debited to the contract account.
Materials returned to store. Whenever materials are issued in excess of requirements, as for instance, cement, sand, pipes, bricks, etc., these are later returned to the store accompanied by a Material Return Note which gives the details of the material returned. Such returned materials are credited to contract account.
Materials at site. At the end of each accounting period, value of materials lying unused at site is credited to contract account and is carried forward for charging against the next period.
2. Cost of Labour - All wages of workers engaged on a particular contract are charged direct to the contract irrespective of the type of work they perform. When several contracts are running at different locations, payroll is normally sectionalised so as to have separate payroll for each contract. Difficulties in costing may be encountered when some workers may have to move from one site to another when a number of small contracts are undertaken. In such situation, it becomes necessary to provide time sheets from which allocations can be made. In order to control labour utilisation and prevent fraud in the payment of wages, surprise visits by head office personnel will be necessary.
3. Plant Depreciation - There are two different methods of dealing with depreciation of plant in contract account:
(a) Contract account is debited with the cost of the plant installed. At the end of the year or when the plant is no longer required, the plant is revalued and contract account is credited with this revalued or depreciated figure. In case plant is sold on the completion of the contract, the contract account is credited with its sale proceeds. The net effect of the above debit and credit will be that the contract account will stand debited with the amount of depreciation which is the difference between the value of plant debited and value of plant credited. The method is generally used on long contracts which extend over more than one year because depreciated value of the plant is credited to the contract account and brought down as an opening balance in the next period.
(b) Alternatively, contract account is simply debited with the amount of depreciation. It is usual to use this method when plant is sent to contract only for a short period. For example, mobile crane or bulldozer used in a contract may be charged on this basis. However, when a plant is hired for a contract, a charge for the hire of the plant is debited to the contract as a direct expense.
4. Subcontract Costs - Work of specialized character, for which facilities are not internally available, is offered to a subcontractor. For example, steel work, glass work, painting, etc., is usually carried out by the subcontractors who are accountable to the main contractor. The cost of such work is charged to the contract account.
5. Payment based on Architect’s Certificate- In case the contract is small, full payment is usually made on the completion of the contract. But in case of large contracts, it may take more than one year to complete. In such a case, if no payment is received until the completion of the contract, the financial resources of the contractor could surely become strained. Therefore, a system of progress payments is agreed by parties. In this system, part payments of the contract amount are paid from time to time on the basis of certificate issued by the architects (acting for the contractee), certifying the value of the work satisfactorily completed. Such payments received by the contractor are usually credited to the personal account of the contractee. It should be noted that such payments are not entered in the Contract Account.
6. Work-in-progress — Work Certified and Uncertified
When the contract is not completed till the end of the accounting year, the architect is required to value the work-in-progress. Such work-in-progress is classified into work certified and work uncertified.
Work Certified. This is that part of the work-in-progress which has been approved by the contractee’s architect or engineer for payment. Work certified is valued at contract price (i.e., selling price), and includes an element of profit.
Work Uncertified. This is that part of the work-in-progress which is not approved by the architect or engineer. This is valued at cost and thus does not include an element of profit. Both work certified and uncertified appear on the credit side of the contract account and also on the assets side of the balance sheet.
7. Retention Money and Cash Ratio - It is usual practice not to pay the full amount of work certified. The contractee may pay a fixed percentage, say 80% or 90% of the work certified, depending upon the terms of the contract. This is known as Cash Ratio. The balance amount not paid is known as Retention Money. For example, if cash ratio is 75%, the retention money will be remaining 25%. This retention money is a type of security for any defective work which may be found in the contract later on. This also works as a deterrent for the contractor to leave the contract incomplete, if he finds the contract unprofitable. The retention money may also be adjusted against penalties that become due if the contract is not completed within the stipulated time as per the terms of the agreement.
8. Extra Work - Sometimes the contractor is required to do some extra work like additions or alterations in the work originally done as per agreement. The contractor will charge extra money for such extra work. The cost of such extra work is debited to the contract account and extra price realized is credited to the contract account.
9. Contract Price
The contract price is the agreed price at which the contractor undertakes to execute the contract.
The contract account is credited with the contract price if it has been completed. In such a case, the amount of contract price is debited to the contractee’s personal account and credited to the contract account.
In incomplete contracts, no entry is passed in respect of the contract price.
10. Cost of Sub-Contracts
Generally, work of a specialized character (e.g., road construction, installation of lifts, and use of electrical fittings) is passed onto another contractor by the main contractor.
In such cases, the work performed by the sub-contractor forms a direct charge to the contract concerned, and the sub-contract price paid should be debited to the contract account.
Q10) Explain cost plus contract.
A10) Cost-plus contract is a contract in which price is not agreed upon in advance for one reason or other. This type of contract is entered into when it is impossible to calculate future price or cost with reasonable accuracy because of lack of past records and experience or because of peculiar circumstances, for example, drilling of oil well.
The contract price is ascertained later by adding a fixed percentage of profit to the total cost of the contract. Different items of expenditure to be considered for ascertaining cost of the contract are agreed upon in advance.
Advantages of Cost-Plus Contract:
For the Contractor:
(1) The contractor is assured of a fixed profit margin.
(2) There is no chance of incurring any loss on the contract.
(3) The contractor is not affected by any fluctuations in the market prices of different elements of cost.
(4) Submission of tenders becomes simple.
For the Contractee:
(1) The contractee feels satisfied because the price is based on actual cost.
(2) In an uncertain situation, the contractee is completely protected.
Disadvantages of Cost-Plus Contract:
For the Contractor:
(1) It discourages contractor to take measures for cost reduction because the profit is based on cost. Lower cost will lead to lower profit.
(2) Disputes may arise between the parties.
For the Contractee:
(1) Generally, profit is based on cost. It encourages wasteful expenditure since the higher the cost, the larger will be the profit.
(2) The amount to be paid by the contractee is uncertain because it cannot be determined until the work is completed. It may create certain problems in cash management.
Q11) Explain fixed price contract and cost-plus contract.
A11) (i) Fixed-Price Contract:
In this type of contract, price is usually fixed and agreed upon in advance. Generally, tenders are invited giving details of the contract to fix up the contract price. As per agreement between the parties, any additional work may be charged separately. There may be a provision in the agreement to allow the contractor to pass to the contractee additional costs incurred due to price rise of materials or wages awards, etc.
(ii) Cost-Plus Contract:
Cost-plus contract is a contract in which price is not agreed upon in advance for one reason or other. This type of contract is entered into when it is impossible to calculate future price or cost with reasonable accuracy because of lack of past records and experience or because of peculiar circumstances, for example, drilling of oil well.
The contract price is ascertained later by adding a fixed percentage of profit to the total cost of the contract. Different items of expenditure to be considered for ascertaining cost of the contract are agreed upon in advance.
Advantages of Cost-Plus Contract:
For the Contractor:
(1) The contractor is assured of a fixed profit margin.
(2) There is no chance of incurring any loss on the contract.
(3) The contractor is not affected by any fluctuations in the market prices of different elements of cost.
(4) Submission of tenders becomes simple.
For the Contractee:
(1) The contractee feels satisfied because the price is based on actual cost.
(2) In an uncertain situation, the contractee is completely protected.
Disadvantages of Cost-Plus Contract:
For the Contractor:
(1) It discourages contractor to take measures for cost reduction because the profit is based on cost. Lower cost will lead to lower profit.
(2) Disputes may arise between the parties.
For the Contractee:
(1) Generally, profit is based on cost. It encourages wasteful expenditure since the higher the cost, the larger will be the profit.
(2) The amount to be paid by the contractee is uncertain because it cannot be determined until the work is completed. It may create certain problems in cash management.
Q12) Explain features and types of contracts?
A12) Contract costing is a type of job costing in which a contract constitutes a unit of cost. The principles of job costing are applicable to contract costing and embrace the same basic principles of cost ascertainment. It is akin to factory job costing, but varies only in size; and the contract continues for a longer time.
A contractor undertakes a small number of big contracts at a time. For example, builders, civil engineering firms, constructional and mechanical engineering firms etc. adopt this method of costing, also known as terminal costing.
The Terminology of I.C.M.A. Defines Contract Costing as – “that form of specific order costing which applies where work is undertaken to customer’s special requirements and each order is of long duration”.
The Terminology of C.I.M.A. Defines Contract Cost as – “the aggregated costs relative to a single contract designated a cost unit”.
Features
Following are the important features of contract costing:
i) The work is carried out away from contractor’s premises i.e., at the contractee’s work site.
Ii) A contract is usually a big job of long-duration and may continue over more than one accounting period.
Iii) As the contracts are of large size, a contractor usually carries out a small number of contracts in the course of a year.
Iv) Contract work involves too much of risk and uncertainty.
v) A contract undertaken is treated as a cost unit.
Vi) A separate account is prepared for each contract to ascertain profit or loss on each contract.
Vii) Apportionment of profit on contract to different accounting periods is very difficult.
Viii) In case the contract is undertaken of long-duration, a percentage of notional profit depending upon the progress of physical work may be accounted for in each year.
Ix) Most of the materials are specially purchased for each contract.
x) Expenses chargeable to contracts are direct in nature, e.g., electricity, telephone charges, insurance etc.
Xi) Allocation and apportionment of overhead costs is a simple task.
Xii) Specialists sub-contractors may be employed for say, electrical fittings, welding works, glass work, plumbing work etc.
Xiii) Plant and equipment may be purchased or hired for the duration of the contract.
Xiv) Nearly all labour will be direct.
Xv) The payment is received depending on the stage of completion of work.
Xvi) A contract usually includes clause for ‘penalty’ for delayed completion.
Xvii) A contract usually includes ‘Escalation Clause’ under which the contractor is compensated for increase in costs on account of inflation.
Xviii) A percentage of the value of work done is deducted from the progress payment as ‘Retention Money’.
Xix) Most of the items of cost are directly chargeable to individual contracts. Administrative overheads and other common costs are apportioned to several contracts on a suitable basis.
Xx) Payments are made on a running account basis depending upon the progress of work as indicated by the certificate of contractor’s architect/ surveyor.
Xxi) A certain amount of profit is taken at the end of the year on incomplete contracts.
Types of contracts
There are two types of contracts:
(i) Fixed price contract and
(ii) Cost-plus contract
(i) Fixed-Price Contract:
In this type of contract, price is usually fixed and agreed upon in advance. Generally, tenders are invited giving details of the contract to fix up the contract price. As per agreement between the parties, any additional work may be charged separately. There may be a provision in the agreement to allow the contractor to pass to the contractee additional costs incurred due to price rise of materials or wages awards, etc.
(ii) Cost-Plus Contract:
Cost-plus contract is a contract in which price is not agreed upon in advance for one reason or other. This type of contract is entered into when it is impossible to calculate future price or cost with reasonable accuracy because of lack of past records and experience or because of peculiar circumstances, for example, drilling of oil well.
The contract price is ascertained later by adding a fixed percentage of profit to the total cost of the contract. Different items of expenditure to be considered for ascertaining cost of the contract are agreed upon in advance.
Advantages of Cost-Plus Contract:
For the Contractor:
(1) The contractor is assured of a fixed profit margin.
(2) There is no chance of incurring any loss on the contract.
(3) The contractor is not affected by any fluctuations in the market prices of different elements of cost.
(4) Submission of tenders becomes simple.
For the Contractee:
(1) The contractee feels satisfied because the price is based on actual cost.
(2) In an uncertain situation, the contractee is completely protected.
Disadvantages of Cost-Plus Contract:
For the Contractor:
(1) It discourages contractor to take measures for cost reduction because the profit is based on cost. Lower cost will lead to lower profit.
(2) Disputes may arise between the parties.
For the Contractee:
(1) Generally, profit is based on cost. It encourages wasteful expenditure since the higher the cost, the larger will be the profit.
(2) The amount to be paid by the contractee is uncertain because it cannot be determined until the work is completed. It may create certain problems in cash management.
