Selling and distribution 10% of Cost of production
D. Plant and Machinery: Depreciation on the plant and machinery used for the contract is to be charged to the contract account. The depreciation may be charged on any of the following basis
VII. Special Aspects Of Contract Account: There are certain special aspects of contract accounts. These are discussed below
Certifi ed Work: In contracts which are expected to continue for a long period of time, it is a normal practice that the contractor obtains certain sums from the contractee from time to time. This is done on the value of contract completed and certifi ed by the architect/surveyor appointed by the contractee. The amount received by the contractor is not 100% of the value of the work certifi ed but is less than the same, as the balance amount is kept as retention money. For recording this transaction, any of the following two methods may be used.
129 I. In the fi rst method, the contract account is credited with the value mentioned in the certifi cate and
personal account of the contractee is debited. Cash received is credited with the contractee’s account and the balance is shown as a debtor representing the retention money.
II. In the second method, the contract account is credited with the value of the certifi cate and the contractee’s account is debited with amount payable immediately and a special retention money account is debited with the amount so retained.
Treatment of Profi t on incomplete Profi t: Several contracts take more time than one fi nancial year before they are complete. The questions arises as to whether the profi ts on such contracts should be taken into consideration after the completion of the contract or whether a portion of the same should be taken into accounts every year on certain basis. If profi t is taken into consideration after the completion of contracts and if in a single year several contracts are completed, the profi ts shown will be very high while in another year, if none of the contracts are completed, amount of profi ts shown will be very low. Thus there will be distortions in the amount of profi ts. Therefore it becomes necessary to compute the amount of profi t on partly completed contracts and take credit of appropriate amount in the profi t and loss account by using the following guidelines.
Value of certifi ed work only should be taken into consideration while determining the profi t.
Value of work not certifi ed should not be taken into consideration.
In case of contracts which are less than 25% complete, no profi ts should be taken into consideration and consequently no credit should be taken to Profi t and Loss Account.
In case of contracts which are more than 25% complete, but less than 50% complete, the following method should be used for computing the profi t to be credited to the Profi t and Loss Account.
1/3 Notional Profi t/ Cash Received/Work Certifi ed. Notional profi t is the difference between the value of work certifi ed and cost of work certifi ed. It is computed in the following manner.
Notional Profi t = Value of work certifi ed – [cost of work to date – cost of work completed but not certifi ed]
In case of contracts complete between 50% and 90% [more than 50% but less than 90%] the following method is used for computing the profi t to be credited to the Profi t and Loss Account.
2/3 Notional Profi t X Cash Received/Work Certifi ed
In case of contracts completed 90% or more than that, it is considered to be almost complete. In such cases, the estimated total profi t is fi rst determined by deducting the total costs to date and additional expenditure necessary to complete the contract from the contract price. The portion of profi t so arrived is credited to the Profi t and Loss Account by using the following formula.
Method I:- Estimated Profi t Work Certifi ed /Contract Price
Method II:- Estimated Profi t Work Certifi ed /Contract Price Cash Received/Work Certifi ed or Estimated Profi t Cash Received/Work Certifi ed. The method II is preferable to the fi rst one.
In case, additional expenditure to complete the contract not mentioned, the amount of profi t to be transferred to the Profi t and Loss Account is determined using the following formula.
Notional Profi t Work Certifi ed/Contract Price
Cost and Management Accounting
130
Methods of Costing - Job, Batch and Contract Costing
If there is a loss, the total amount of loss should be transferred to the Profi t and Loss Account by crediting the contract account.
It will be observed that in case of incomplete contract, amount of profi t credited to the Profi t and Loss Account is reduced proportionate to the work certifi ed and cash received. The reason is that this being unrealized profi ts should not be used for distribution of dividend. Similarly, the principle of conservatism should also be applied in computing and crediting the profi ts.
Illustration: Compute a conservative estimate of profi t on a contract [80% complete] from the following particulars. Illustrate at least four methods of computing the profi t.
Particulars Amount [Rs.]
Total expenditure to date 1, 02,000
Estimated further expenditure to complete the contract [including contingencies]
20, 400
Contract price 1, 83,600
Work certifi ed 1, 20,000
Work uncertifi ed 10, 200
Cash received 97, 920
Solution: The amount of profi t on incomplete contract can be computed according to any of the following four methods. Before computing the same, we will compute the amount of profi t on the contract and then show the working of the methods.
Profi ts on incomplete contract:
Total Contract Price: Rs. 1, 83, 600
Less: Expenditure to date: Rs. 1, 02, 000
Estimated further expenditure: Rs. 20, 400
Total expenditure Rs. 1, 22, 400
Estimated Profi ts Rs.61, 200
o Amount of Profi t to be taken to the Profi t & Loss A/c o 1st Method: Rs.61, 200/Rs.183600 Rs.120000 = Rs.40, 000
o 2nd Method: Estimated Profi ts Work Certifi ed/Contract Price Cash Received/Work Certifi ed
o Rs.61200 Rs.120000/Rs.183600 Rs.97920/Rs.120000 = Rs.32640
o 3rd Method: Estimated Profi ts Cost of Work to date/Estimated Total Cost o Rs.61200 Rs.102000/Rs.122400 = Rs.51000
o 4th Method: Estimated Profi ts Cost of Work to Date/Estimated Total Cost Cash Received /Work Certifi ed
o Rs.61200 Rs.102000/Rs.122400 Rs.97920/120000 = Rs.41616
131 Special Points in Contract:
I. Cost Plus Contracts: This type of contract is generally adopted when the probable cost of contract cannot be ascertained in advance with reasonable accuracy. In this type of contract, the contractor receives his total cost plus a profi t, which may be a percentage of cost. These types of contracts give protection to the contractor against fl uctuations in profi ts as he is guaranteed about his profi t irrespective of the actual costs. However in order to avoid any dispute in future, it is always advisable to specify the admissible costs in advance. Similarly the customer may also reserve the right of demanding ‘cost audit’ in order to check the reliability of the claim of the contractor regarding increase in the costs.
II. Target- price contracts: In such cases, the contractor receives an agreed sum of profi t over his pre- determined costs. In addition, a fi gure is agreed as the target fi gure and if actual costs are below this target, the contractor is eligible for bonus for the savings.
III. Escalation Clause: In order to protect the contractor from the rise in the price, an escalation clause may be inserted in the contract. As per this clause, the contract price is increased proportionately if there is a rise in input costs like material, labor or overheads. The condition that may be laid down is that the contractor will have to produce a proof regarding the rise in the price.
Problems and Solutions
Contract Costing
1. M/s New Century Builders have entered into a contract to build an offi ce building complex for Rs.480 lakhs. The work started in April 1997 and it is estimated that the contract will take 15 months to be completed. Work has progressed as per schedule and the actual costs charged till March 1998 was as follows.
Particulars Amount Rs.in
lakhs
Materials 112.20
Labor 162.00
Hire charges for equipment and other expenses 36.00
Establishment charges 32.40
The following information are available:
Particulars Amount – Rs.
in lakhs
Material in hand 31st March 1998 10.50
Work certifi ed [of which Rs.324 lakhs have been paid] as on 31st March 1998 400.00
Work not certifi ed as on 31st March 1998 7.50
As per Management estimates, the following further expenditure will be incurred to complete the work.
Materials: Rs.10.50 lakhs Labor: Rs.16.00 lakhs
Sub-contractor: Rs.20.00 lakhs
Cost and Management Accounting
132
Methods of Costing - Job, Batch and Contract Costing
Equipments hire and other charges: Rs.3.00 lakhs Establishment charges: Rs.6.90 lakhs
You are required to compute the value of work-in-progress as on March 31st, 1998 after considering a reasonable margin of profi t and show the appropriate accounts. Make a provision for contingencies amounting to 5% of the total costs.
Solution: The following accounts are prepared.
Dr. Contract A/c Cr
Particulars Amount Rs. Particulars Amount Rs.
To Materials 1,12,20,000 By Stock of materials 6,60,000
To Labor 1,62,00,000 By Work-in-progress
Work certifi ed: 4,00,00,000
Work uncertifi ed: 7,50,000 4,07,50,000
To Hire charges 36,00,000
To Establishment charges 32,40,000
To Profi t c/d 71,50,000
Total 4,14,10,000 Total 4,14,10,000
To Profi t & Loss A/c * 50,00,000 By Profi t b/d 71,50,000
To Reserve [Transfer] 21,50,000
Total 71,50,000 Total 71,50,000
Dr. Contractee’s A/c Cr
Particulars Amount Rs. Particulars Amount Rs
To Contract A/c 4,00,00,000 By Bank A/c 3,24,00,000
By Balance c/d 76,00,000
Total 4,00,00,000 Total 4,00,00,000
*Amount of profi t to be taken to the Profi t and Loss A/c has been computed as shown below.
Particulars Amount Rs. Amount Rs.
Expenditure up to 31st March 1998
Rs.3,42,60,000 [Total of debit side] – Rs.6,60,000 3,36,00,000 Add: Estimated expenditure to complete
Materials: 10,50,000 + Closing stock Rs.6,60,000 17,10,000
Labor 16,00,000
Sub-contractor 20,00,000
Hire charges on equipment 3,00,000
Establishment charges 6,90,000
Total 63,00,000
Add: 5% on total cost for contingencies, i.e. Rs.3,99,00,000 X 5/95 21,00,000
133
Total cost - estimated 4,20,00,000
Total profi t - estimated 60,00,000
Contract price 4,80,00,000
Profi t to be taken to the Profi t and Loss A/c = Total Estimated Profi ts Work Certifi ed/Contract Price
Rs.60,00,000 Rs.4,00,00,000 /Rs.4,80,00,000 = Rs.50,00,000
2. Deluxe Ltd. undertook a contract for Rs.5,00,000 as on 1st July 2006. On 30th June 2007, when the accounts were closed, the following details about the contract were gathered.
Particulars Amount
Rs.’000s
Materials purchased 100
Wages paid 45
General expenses 10
Plant purchased 50
Materials on hand on 30th June 2007 25
Wages accrued on 30th June 2007 5
Work certifi ed 200
Cash received 150
Work uncertifi ed 15
Depreciation of plant 5
The above contract contained an escalation clause which read as follows.
‘ In the event of materials and rates of wages increase by more than 5% the contract price would be increased accordingly by 25% of the rise in the cost of materials and wages beyond 5% in each case’.
It was found that since the date of signing the agreement, the prices of materials and wage rates increased by 25%. The value of work certifi ed does not take into account the effects of the above clause. Prepare Contract Account. Working should form part of your answer.
Solution: On next page.
Dr. Contract A/c for the Year Ended 30th June 2007 Cr.
Particulars Amount Rs. Particulars Amount Rs.
To Materials 1,00,000 By Work-in-progress A/c:
To Wages paid 45, 000 Work certifi ed 2,00, 000
To Wages outstanding 5, 000 Work uncertifi ed 15, 000
To General expenses 10, 000 Materials on hand 25, 000
To Depreciation of Plant 5, 000 Contract escalation * 5, 000 To Balance c/d – notional profi t 80, 000
Total 2,45, 000 Total 2,45, 000
To Profi t and Loss A/c # 20, 000 By Balance b/d 80, 000
Cost and Management Accounting
134
Methods of Costing - Job, Batch and Contract Costing
To Transfer to Reserve 60, 000
Total 80, 000 Total 80, 000
* Escalation:
Materials /wages increased by 25%
[a] Increase in material price [Rs.100000 – Rs.25000] 25/125 = Rs.15,000 [b] Increase in wages Rs.50,000 25/125 = Rs.10,000
Total Increase = [a] + [b] = Rs.25,000 This increase is 5% of the contract price.
Escalation is 25% of the rise in the cost of materials and wages beyond 5% in each case.
25% increase = Rs.25, 000 and hence 5% increase = Rs.5, 000 Escalation = 25% of [Rs.25, 000 – Rs.5, 000] = Rs.5, 000
# Amount of profi t to be credited to Profi t and Loss A/c: As the contract is less than 50% complete, the following formula will have to be used for computing the amount of profi t to be credited to the Profi t and Loss A/c
1/3 Cash Received/Work Certifi ed Notional Profi t 1/3 Rs.1, 50, 000/2,00,000 Rs.80,000 = Rs.20,000
3. Construction Ltd. is engaged in two contracts, A and B during the year. Following information is available at the year- end.
Particulars Contract A Rs. Contract B Rs.
Date of commencement April 1st September 1st
Contract price 6,00,000 5,00,000
Materials delivered direct to site 1,20,000 50,000
Materials issued from store 40,000 10,000
Materials returned to store 4,000 2,000
Material on site on December 31st 22,000 8,000
Direct labor payments 1,40,000 35,000
Direct expenses 60,000 30,000
Architect’s fees 2,000 1,000
Establishment charges 25,000 7,000
Plant installed at cost 80,000 70,000
Value of plant on 31st December 65,000 64,000
Accrued wages 31st December 10,000 7,000
Accrued expenses 31st December 6,000 5,000
Cost of contract not certifi ed by architect 23,000 10,000 Value of contract certifi ed by architect 4,20,000 1,35,000
Cash received from contractor 3,78,000 1,25,000
135 During the period, materials amounting to Rs.9, 000 have been transferred from contract A to contract B. You are required to show,
[a] Contract A/c, Contractee A/c and
[b] Extract from the Balance Sheet as on 31st December showing the calculation of WIP Solution:
Dr. Contract A A/c Cr
Particulars Amount Rs. Particulars Amount Rs.
To Direct materials 1,20,000 By Materials returned to stores 4,000 To materials issued from stores 40,000 By Material transferred to contract B 9,000
To Wages paid 1,40,000 By Stock of materials c/d 22,000
To Direct expenses 60,000 By Work certifi ed 4,20,000
To Depreciation of Plant 15,000 By Work not certifi ed 23,000
To Architect’s fees 2,000
To Establishment charges 25,000
To Wages accrued 10,000
To Direct expenses accrued 6,000 To Notional profi t c/d 60,000
Total 4,78,000 Total 4,78,000
To Profi t & Loss A/c * 36,000 By Notional profi t c/d 60,000 To Transfer to Reserve 24,000
Total 60,000 Total 60,000
Dr Contractee A/c Cr
Particulars Amount Rs. Particulars Amount Rs.
To Value of work certifi ed 4,20,000 By Cash received 3,78,000
By Balance c/d 42,000
Total 4,20,000 Total 4,20,000
* Amount of profi t to be taken to Profi t and Loss A/c is computed as shown below.
2/3 Notional Profi t Cash Received / Work Certifi ed 2/3 Rs.60, 000 Rs.3, 78, 000 /Rs.4, 20, 000 = Rs.36, 000
As the contract is 75% complete, 2/3rd of notional profi t is taken into consideration
Dr. Contract B A/c Cr
Particulars Amount Rs. Particulars Amount Rs.
To Direct materials 50,000 By Materials returned to stores 2,000 To materials issued from stores 10,000 By Stock of materials c/d 8,000
To Material from A 9,000 By Work certifi ed 1,35,000
Cost and Management Accounting
136
Methods of Costing - Job, Batch and Contract Costing
To Wages paid 35,000 By Work not certifi ed 10,000
To Direct expenses 30,000 By Profi t and Loss A/c - Loss 5,000 To Depreciation of Plant 6,000
To Architect’s fees 1,000
To Establishment charges 7,000
To Wages accrued 7,000
To Direct expenses accrued 5,000
Total 1,60,000 Total 1,60,000
Dr Contractee A/c Cr
Particulars Amount Rs. Particulars Amount Rs.
To Value of work certifi ed 1,35,000 By Cash received 1,25,000
By Balance c/d 10,000
Total 1,35,000 Total 1,35,000
Extracts from Balance Sheet is shown on the next page.
Balance Sheet as on 31st December [Extract only for contract]
Liabilities Amount Rs Assets Amount Rs.
Profi t & Loss A/c Fixed Assets:
Profi t of A: 36,000
4. A company undertook a contract for construction of a large building complex. The construction work commenced on 1st April 2005 and the following data are available for the year ended on 31st March 2006.
137
Materials returned from site 250
Plant hire charges 1,750
Wages related costs 500
Site offi ce costs 678
Head offi ce expenses apportioned 375
Direct expenses incurred 902
Work not certifi ed 149
The contractors own a plant which originally cost Rs.20 lakhs has been continuously in use in this contract throughout the year. The residual value of the plant after 5 years of life is expected to be Rs.5 lakhs. Straight-line method of depreciation is in use. As on 31st March 2006, the direct wages due and payable amounted to Rs.2, 70, 000 and the materials at site were estimated at Rs.2, 00,000.
Required:
[a] Prepare the contract account for the year ended 31st March 2006
[b] Show the calculation of profi ts to be taken to the Profi t and Loss A/c of the year [c] Show the relevant Balance Sheet entries.
Solution:
Dr. Contract A/c for the Year Ended 31st March 2006 Cr.
Particulars Amount
Rs. 000s
Particulars Amount
Rs. 000s To Materials issued 7, 500 By Materials returned to site 250
To Direct wages paid 4, 000 By Material at site 200
To Wages related costs 500 By Work-in-progress
Work certifi ed: 20,000
Work uncertifi ed: 149 20, 149
To Direct expenses 902
To Plant hire charges 1, 750
To Planning and Estimation Costs 1, 000
To Site offi ce costs 678
To Head Offi ce expenses apportioned
375
To Depreciation of Plant * 300
To Direct wages accrued 270
To Notional profi t c/d 3, 324
Total 20, 599 Total 20, 599
Cost and Management Accounting
138
Methods of Costing - Job, Batch and Contract Costing
Dr. Contract A/c [Continued From Previous Page] Cr