Contract Costing & Replacement Decisions: Methods, Analysis & Real-World Applications

TAKEAWAYS:

• Contract costing tracks revenue and costs for long-term projects (e.g., construction, infrastructure) using either percentage-of-completion (recognizing profit as work progresses) or completed-contract (recognizing profit only at completion).
• Replacement decisions compare incremental costs (difference in costs between old and new assets) to justify upgrades, using metrics like annual savings or payback period.
• Key formulas:
  • Percentage-of-completion profit = (Work done/Total work) × Total estimated profit.
  • Incremental cost = (Cost of new asset – Salvage value of old asset) + Annual savings.
• Real-world ties: NTC uses contract costing for telecom tower projects; Daraz’s warehouse expansions rely on replacement decisions for machinery.
• Exam focus: Numerical problems dominate (30–50% of marks). Master tracing costs to contracts, calculating profit recognition, and comparing replacement scenarios.
• Common pitfalls: Ignoring unabsorbed overheads in contract costing or misapplying time value of money in replacement analysis.

1. Contract Costing: Definitions and Methods

Contract costing is used for long-term projects (e.g., building a bridge, erecting a telecom tower, or constructing a residential complex) where work spans multiple accounting periods. Unlike job order costing (for short-term jobs), contract costing allocates costs and revenues over the project’s lifespan.

Key Terms

Two Methods of Revenue Recognition

Contract costing uses two primary methods to recognize revenue and profit:

A. Percentage-of-Completion Method (Accrual Basis)

• Revenue and profit are recognized proportionally as work progresses.
• Used when: Work can be reliably measured (e.g., % of physical completion).
• Formula:

  Profit for the period = (Work done/Total estimated work) × Total estimated profit
  

• Advantages:
  • Matches revenue with expenses (accrual accounting).
  • Provides better financial visibility for stakeholders.
• Disadvantages:
  • Requires accurate estimates of total work and costs.
  • Complexity in measuring "work done" (e.g., for software projects).

B. Completed-Contract Method (Cash Basis)

• Revenue and profit are recognized only upon completion.
• Used when: Work cannot be reliably measured (e.g., research projects).
• Advantages:
  • Simpler to implement.
  • Avoids estimation risks.
• Disadvantages:
  • Distorts financial statements (revenue/profit lags).
  • May violate accrual principles.

Contract costing in action (e.g., Kathmandu’s Ring Road expansion) (Image: Bidgee, CC BY-SA 3.0 au, via Wikimedia Commons)

2. How Contract Costing Works: A Step-by-Step Trace

Let’s trace a 3-year contract for Kathmandu Metropolitan City (KMC) to build a new drainage system in Thapathali.

Given Data

Year 1: Percentage-of-Completion Method

1. Work Certified: 40% of total work.

2. Profit Recognized:

   Profit = (40/100) × 50M = Rs. 20 million
   

3. Revenue Recognized:

   Revenue = (40/100) × 300M = Rs. 120 million
   

4. Journal Entry:

   | Particulars               | Dr (Rs.) | Cr (Rs.) |
   |---------------------------|----------|----------|
   | Work-in-Progress (WIP)    | 80,000,000 |          |
   | Contract Revenue          |          | 120,000,000 |
   | Profit on Contract        | 20,000,000 |          |
   | Cash/Bank                 |          | 80,000,000 |
   | **Total**                 | **100,000,000** | **200,000,000** |
   

   • Explanation:
     • WIP is debited for actual costs (Rs. 80M).
     • Revenue is credited for 40% of contract price (Rs. 120M).
     • Profit (Rs. 20M) is recognized immediately.

5. Balance Sheet Impact:

   • Asset (WIP): Rs. 80M (cost) + Rs. 20M (profit) = Rs. 100M.
   • Liability (Billings): Rs. 120M (revenue recognized).

Year 2: Continuing the Contract

1. Work Certified: Cumulative 75% (40% + 35%).
2. Profit Recognized in Year 2:

   Total profit for 75% = (75/100) × 50M = Rs. 37.5M
   Profit in Year 2 = 37.5M – 20M (Year 1) = Rs. 17.5M
   

3. Revenue Recognized:

   Revenue = (75/100) × 300M = Rs. 225M
   

4. Journal Entry:

   | Particulars               | Dr (Rs.) | Cr (Rs.) |
   |---------------------------|----------|----------|
   | WIP                       | 100,000,000 |          |
   | Contract Revenue          |          | 225,000,000 |
   | Profit on Contract        | 17,500,000 |          |
   | Cash/Bank                 |          | 100,000,000 |
   | **Total**                 | **117,500,000** | **325,000,000** |
   

   • Note: Only Rs. 17.5M profit is recognized in Year 2 (not Rs. 37.5M).

Year 3: Completion

1. Work Certified: 100%.
2. Profit Recognized:

   Remaining profit = 50M – (20M + 17.5M) = Rs. 12.5M
   

3. Journal Entry:

   | Particulars               | Dr (Rs.) | Cr (Rs.) |
   |---------------------------|----------|----------|
   | WIP                       | 70,000,000 |          |
   | Contract Revenue          |          | 300,000,000 |
   | Profit on Contract        | 12,500,000 |          |
   | Cash/Bank                 |          | 70,000,000 |
   | **Total**                 | **82,500,000** | **370,000,000** |
   

MERMAID DIAGRAM: Contract Costing Cycle

flowchart TD
    A["Start Contract\n(Year 0)"] --> B["Estimate Total Cost & Profit"]
    B --> C["Year 1: Incur Costs\nMeasure Work Progress"]
    C --> D["Recognize Revenue & Profit\n(Percentage-of-Completion)"]
    D --> E["Year 2: Repeat\nCosts & Progress"]
    E --> F["Update WIP & Profit"]
    F --> G["Year 3: Complete\nFinalize Accounts"]
    G --> H["Close Contract\nTransfer Profit to P&L"]

3. Handling Overheads and Unabsorbed Costs

In contract costing, overheads (indirect costs like rent, salaries) are allocated to contracts using a predetermined overhead rate:

Overhead Rate = (Total Estimated Overheads) / (Total Estimated Direct Costs)

Example: If total overheads are Rs. 50M and direct costs Rs. 200M, the rate is 25% (50M/200M).

Unabsorbed Overheads

If actual overheads exceed allocated overheads, the unabsorbed amount is treated as:

• Loss (if recognized in profit and loss).
• Part of WIP (if carried forward).

Journal Entry for Unabsorbed Overheads:

| Particulars               | Dr (Rs.) | Cr (Rs.) |
|---------------------------|----------|----------|
| Profit & Loss A/c         | 10,000,000 |          |
| Factory Overhead A/c      |          | 10,000,000 |

4. Replacement Decisions: Theory and Application

Replacement decisions involve comparing the costs of retaining an old asset vs. purchasing a new one. The key is to focus on incremental costs (differences between the two options).

Key Concepts

Step-by-Step Replacement Decision Analysis

Scenario: Kathmandu Wool Industries is considering replacing an old weaving machine.

• Old Machine:
  • Book Value: Rs. 2,000,000
  • Salvage Value (now): Rs. 300,000
  • Annual Maintenance: Rs. 500,000
  • Remaining Life: 5 years
• New Machine:
  • Cost: Rs. 4,000,000
  • Salvage Value (after 5 years): Rs. 500,000
  • Annual Maintenance: Rs. 100,000
  • Life: 5 years
• Assumptions:
  • No income tax effects.
  • Discount rate: 10%.

Step 1: Calculate Incremental Cost

Incremental Cost = (Cost of new machine – Salvage value of old machine)
                 = (4,000,000 – 300,000)
                 = Rs. 3,700,000

Step 2: Calculate Annual Savings

Annual Savings = (Maintenance of old – Maintenance of new)
               = (500,000 – 100,000)
               = Rs. 400,000

Step 3: Compute Payback Period

Payback Period = Incremental Cost / Annual Savings
               = 3,700,000 / 400,000
               = 9.25 years

Conclusion: The payback period exceeds the machine’s life (5 years), so do not replace (without considering other factors like efficiency gains).

Step 4: Net Present Value (NPV) Approach (Advanced)

If we discount the annual savings at 10%:

NPV = -3,700,000 + (400,000 / 1.1^1) + (400,000 / 1.1^2) + ... + (400,000 / 1.1^5)
    ≈ -3,700,000 + 1,635,000 (present value of savings)
    ≈ -2,065,000 (Negative NPV → Reject)

MERMAID DIAGRAM: Replacement Decision Flowchart

flowchart TD
    A["Old Asset vs. New Asset?"] --> B["Calculate Incremental Cost"]
    B --> C["Estimate Annual Savings"]
    C --> D["Compute Payback Period"]
    D --> E{"Payback ≤ Asset Life?"}
    E -->|"Yes"| F["Consider NPV/DCF"]
    E -->|"No"| G["Reject Replacement"]
    F --> H{"NPV > 0?"}
    H -->|"Yes"| I["Accept Replacement"]
    H -->|"No"| G

5. Real-World Applications in Nepal

Example 1: NTC’s Telecom Tower Construction

• Contract Type: Long-term construction (3–5 years).
• Method Used: Percentage-of-completion (NTC requires progress-based billing).
• Why? Ensures NTC pays contractors fairly as towers are built, improving cash flow for both parties.
• Challenge: Accurately measuring "work done" (e.g., % of steelwork completed).

Example 2: Daraz’s Warehouse Automation

• Scenario: Daraz is replacing old conveyor belts in its warehouse.
• Decision: Compare incremental costs of new belts (Rs. 8M) vs. annual savings (Rs. 1.5M/year).
• Outcome: Payback period = 5.33 years → Justified if belts last >5 years.

Example 3: Kathmandu’s Public Bus Fleet

• Harati Yatayat Sewa (a public bus company) must decide whether to:
  1. Repair old buses (cost: Rs. 2M/bus, life: 2 years).
  2. Buy new buses (cost: Rs. 8M/bus, life: 10 years, lower fuel costs).
• Analysis:
  • Incremental Cost: Rs. 8M – Rs. 2M = Rs. 6M.
  • Annual Savings: Rs. 1.2M (fuel + maintenance).
  • Payback: 6M / 1.2M = 5 years (within new bus life).

6. Comparison Table: Contract Costing vs. Job Order Costing

7. Common Mistakes in Exams

1. Ignoring Unabsorbed Overheads: Always check if overheads are fully absorbed in contracts.
2. Miscounting Work Progress: Ensure percentages add up to 100% at completion.
3. Forgetting Salvage Value: In replacement decisions, subtract old asset’s salvage value from new cost.
4. Mixing Methods: Don’t use percentage-of-completion for a completed-contract scenario.
5. Time Value Errors: In NPV calculations, discount future savings correctly.

8. Worked Example: Combined Contract Costing and Replacement

Scenario: Everest Engineering has a 2-year contract to build a hydroelectric dam for NEPSE. They must also decide whether to replace an old excavator.

Part A: Contract Costing

Year 1 Entries:

Profit = (60/100) × 50M = Rs. 30M
Revenue = (60/100) × 200M = Rs. 120M

Journal Entry:

| Particulars               | Dr (Rs.) | Cr (Rs.) |
|---------------------------|----------|----------|
| WIP                       | 90,000,000 |          |
| Contract Revenue          |          | 120,000,000 |
| Profit on Contract        | 30,000,000 |          |
| Cash/Bank                 |          | 90,000,000 |

Part B: Replacement Decision

• Old Excavator:
  • Book Value: Rs. 10M
  • Salvage Value: Rs. 2M
  • Annual Maintenance: Rs. 3M
  • Life: 3 years
• New Excavator:
  • Cost: Rs. 20M
  • Salvage Value: Rs. 4M
  • Annual Maintenance: Rs. 1M
  • Life: 5 years

Incremental Cost:

20M (new) – 2M (old salvage) = Rs. 18M

Annual Savings:

3M (old) – 1M (new) = Rs. 2M

Payback Period:

18M / 2M = 9 years > 5 years (new life) → **Reject**

## In the Real World

1. NTC’s Telecom Expansion

   • What’s Used: Percentage-of-completion method for tower construction contracts.
   • How: NTC pays contractors 60% of the contract value after 60% of the tower is physically completed (verified by independent auditors).
   • Why: Ensures funds are used efficiently and contractors stay solvent during long projects.

2. Daraz’s Warehouse Automation

   • What’s Used: Replacement decision analysis for conveyor belts and sorting machines.
   • How: Daraz calculates payback periods for new equipment. For example, replacing a Rs. 5M forklift that saves Rs. 800K/year in labor gives a 6.25-year payback—justified if the forklift lasts 8+ years.
   • Nepali Tie: Daraz’s Kathmandu warehouse uses this to optimize order fulfillment speed.

3. Kathmandu’s Road Construction (KMC Contracts)

   • What’s Used: Completed-contract method for small, short-term road repairs (where work progress is hard to measure).
   • Example: A Rs. 20M contract to repair 10 km of roads in Chobhar might recognize zero profit until the entire project is certified "complete" by KMC engineers.
   • Challenge: Delays in certification can strain contractor cash flow.

4. Nepal Electricity Authority (NEA) Dam Projects

   • What’s Used: Contract costing with overhead absorption.
   • How: NEA allocates central overheads (e.g., HQ salaries) to dam projects based on direct labor hours. If a project runs over budget, unabsorbed overheads are treated as a loss for the year.

## Exam Tip: How to Score Full Marks

1. For Contract Costing Problems:

   • Always show work progress percentages and how they relate to profit recognition.
   • Label WIP, revenue, and profit clearly in journal entries.
   • Mention unabsorbed overheads if given (even if zero).

2. For Replacement Decisions:

   • Calculate incremental cost first (most students miss this).
   • Compare payback period to asset life—this is the key decision criterion in basic problems.
   • For advanced questions, use NPV (but only if asked).

3. Numerical Accuracy:

   • Double-check percentages (e.g., 60% + 40% = 100%).
   • Use tables for contract costing traces (examiners love this).

4. Theoretical Questions:

   • Define percentage-of-completion and completed-contract clearly.
   • Mention advantages/disadvantages of each method (e.g., accrual vs. cash basis).

5. Real-World Links:

   • If asked about applications, name NTC, Daraz, or KMC and tie to contract costing/replacement.
   • Example answer: "NTC uses percentage-of-completion for telecom tower contracts to ensure fair revenue recognition as towers are built."

MERMAID DIAGRAM: Exam Checklist

mindmap
  root((Contract Costing & Replacement Exam Tips))
    Contract Costing
      Work Progress %s
      Profit Recognition Formula
      Journal Entries (WIP, Revenue, Profit)
      Unabsorbed Overheads
    Replacement Decisions
      Incremental Cost Calculation
      Annual Savings
      Payback Period vs. Asset Life
      NPV (if advanced)
    General
      Label All Figures
      Show Workings Clearly
      Use Tables for Traces
      Link to Real-World (NTC/Daraz)