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# BBA Study Material to Cost Accounting Topic Wise Notes of Contract Costing

## Costing of Running Contracts

The long – term nature of contracts has necessitated to determining profit to be attributed to each accounting period. In the long – term contracts it is considered that their outcome can be assessed with reasonable with reasonable certainty before their conclusion, the attributable profit should be calculated on a prudent basis and included in the accounts for the period under review. The profit taken up should be based on standard cost accounting principles. In case of completed contracts all the profit that arise from the contract can be transferred to profit and loss account. But in case of incomplete contracts, only portion of the profit is taken to the profit and loss account depending on the extent of work completed on the contract because some provision is to be made for meeting contingencies and unforeseen loss. There are no hard and fast rules in calculation of profit to be taken to profit and loss account. But in general, the following principles are followed:

• If loss is arrived on incomplete contracts, the entire loss is debited to profit and loss account.
• Profit should be considered only in respect of work certified. The uncertified work should be valued at cost.
• If the amount of work certified is less than 25% of the contract price, then no profit should be taken to profit and loss account, and the entire amount is kept as reserve for meeting contingencies.
• If the amount of work certified is more than 25% but less than 50% of the contract price, then 1/3 rd of profit ascertained as reduced by percentage of cash received from the contractee should be taken to the profit and loss account. The balance will remain as reserve for meeting contingencies. The formula is given below:
• If the amount of work certified is 50% or more of the contract price, then 2/3rd s of profit ascertained as reduced by percentage of cash received from the contractee is to be taken to profit and loss account, keeping the remaining amount in reserve. The formula is given below:

## Costing of Contracts Nearing Completion

if the contract is nearing completion, the total cost of completing the contract may be estimated  is possible and then ascertain the estimated to  total profit . the amount of profit to be transferred to the profit and loss account, is calculated by applying the following formula:

The balance amount of profit not transferred to profit and loss account but kept as reserve for meeting contingencies is shown in the balance sheets side by deducting it from the amount of work – in – progress. It is carried down as a credit balance in the contract account itself, the work – in – progress being represented by the debit balance in the contract account.

## Cost plus Contracts

Cost plus contracts for payment of allowable actual costs plus an agreed element to cover the profit as incentive. Cost plus contracts will be entered mainly in the following situation:

• Existence of sole supplier of product or service.
• Product or service is highly complex in nature and the costs cannot be predetermined.
• When the product or service is a new or special one for which no cost estimates are available.
• In a highly inflationary situation cost plus basis is more secure when the estimates based on current costs are uncertain.

Cost plus contracts are more popular in government for defense equipment and components, ships, aircraft, etc.

### Principles Guiding Cost plus Contracts

The important guiding principles in cost plus contracts are as follows:

• The costs incurred for the contract should be reasonable. The term costs should be clearly defined at the time of entering into contract. Reasonableness of cost depends on the circumstances of a particular contract.
• The costs should be allowable to the contract based on the benefit derived from incurring such costs. The cost allocation should be fairly equitable.
• Cost plus contracts are based on absorption costing technique in which total allocation of costs will be taken into consideration.
• ‘Plus’ in the cost plus formula is to be determined by the parties by mutual agreement. Profit may be to the allowable cost as an agreed percentage of total allowable cost or it may be added as a mark – up profit. Return on capital employed for the contract is the prudent and fair policy in allowing profit in cost plus contract.
• Usage of material and labour, normal wastage and spoilage allowance, idle time allowance, rate of material and labour should be predetermined. Credits from disposal of waste and scrap should be agreed upon.
• Abnormal losses, windfall profits and gains should not be included in cost.
• If special machinery and equipment are acquired for the purpose of execution of contract, any wear and tear, obsolescence costs are chargeable to the cost of the contract. If it is partly used , costs should be allocated properly.

### Bid Costing and Cost plus Contract Costing

The major distinguishing factors between bit costing and cost plus contract costing can be visualized in the following cased:

• Cost plus contract costing system protects the contract from recurring fluctuation in market price of inputs – material, labour and overheads. The notional revenue in come can be estimated in advance of time on job completion. The risk of loss on the contract costs are covered through agreement with contractor.

Where in bid costing, the myopic vision of the contractor do not pave the way to protection. The burden of fluctuation on the cost of inputs generally lies on the bidder alone if he does not foresee the onslaught and does not incorporate an escalation clause in the bidding contract.

• Cost plus contract costing method ensures that the price paid by the contractee depend absolutely on cost rather than on commitment of the contractor. Under uncertainty of expenditure, the contractor pays only the reasonable price on contract. Whereas in bid costing, the bidder have to take into consideration the trends in the market as per inputs. Its availability cost content and price etc.
• Both cost plus contract and bid costing are based on cost estimates as per cost of required inputs from contract commitments. The only distinguishing factor most striking is the certainty and uncertainty elements involved.

Bba Study Material to Cost Accounting of Contract Costing Topic is Fixed Price Contract with Escalation Clause Short Notes

## Fixed Price Contract with Escalation Clause

The method consists of escalation clauses to contracts for future deliveries. It is obvious that if increasing prices ahead of the rate at which costs are rising becomes general practice, this will not just perpetuate but actually accelerate the inflationary tendency. On the other hand, contracts with escalation clauses can be claimed to be of advantage our both to the supplier and to the customer. In so far as they provide protection to the supplier against cost increases, while the customer is assured that he will not be charged more than the appropriate volume of the goods concerned at the time of delivery.

Properly constructed escalation clauses should cover the following points:

• Description of the elements of cost those are subject to escalation.
• Stipulation of the index to be applied to each cost category.
• Indication of the frequency with the cost elements concerned may be increased or decreased during specific periods or over the length of the contract.
• The contract should indicate whether changes mean only rises or also falls in prices. The benefit of lower prices should be transferred to the consumer.
• Whether only price/ rate variance should affect the total payment or also quantity variance should be taken into consideration, normally, the quantity variance is the responsibility of the contractor and cannot be transferred to the contractee.
• Price or rate variance normally means the purchase price of materials or wage rates incurred by the contractor from time to time. It is imperative that the contractee should have power to investigate or audit the relevant invoices or pay roll. It may also need certain provisions in the contract, whether the contractor is incurring such expenses prudently at prevailing rates in the market.

## Summary

• Contract costing is a form of specific order costing where substantial time and costs are involved and the completion of contract falls into different accounting periods.
• The contract work is undertaken on the site and it mainly consists of construction activities.
• In case of complete contracts profits are transferred to profit and loss account.
• In case of incomplete contracts, only a portion of the profit is taken to the profit and loss account depending on the extent of work completed on the contract, keeping some provision for meeting contingencies and unforeseen loss.
• The transfer of profit depends on company’s own policy, but the costing principles are evolved in determination of such transferable profit.
• A surveyor will scrutinise the work – in – progress and issues a certificate mentioning the stage of completion of contract on the date of issue of certificate.
• The payments are released to the contractor by the contractee based on the surveyor’s certificate after retaining a part of the amount of work certified as retention money to safeguard from the risks that may arise from the contractor.
• In a cost plus contract a clause is provided for payment of allowable actual costs plus an agreed amount to cover the profit as incentive.
• In fixed price contract with escalation clause, the contractor can claim for increase In prices of inputs to the agreed extent.