How to Calculate Profit or Loss on Incomplete Contracts?

The profit or loss on incomplete contracts in cost accounting can be calculated using the percentage of completion method. This method recognizes profit or loss on a contract in proportion to the percentage of work completed.

Profit of Loss on Incomplete Contract – Calculation

To calculate the profit or loss on an incomplete contract using the percentage of completion method, you need to know the following information:

• The contract price
• The total estimated costs of the contract
• The percentage of work completed

There are three cases of calculation of profit on incomplete contracts.

Case 1: If the work certified is less than 25%

No profit should be transferred to the profit and loss account.

Case 2: Work certified is 25% or more but less than 50%

Step1 Calculate the Notional Profit:

Value of Work Certified	XXX
Less: Cost of Work Certified	(XX)
Notional Profit	XXX

Step 2: Calculation of Profit

= 1/3 x Notional Profit x (Cash Received/Value of Work Certified)

Case 3: If work certified is more than 50% but less than 90%

Step1 Calculate the Notional Profit:

Value of Work Certified	XXX
Less: Cost of Work Certified	(XX)
Notional Profit	XXX

Step 2: Calculation of Profit

= 2/3 x Notional Profit x (Cash Received/Value of Work Certified)

Case 4: The Contact is nearing completion

Estimated profit x (Cash received/work certified) x (Work certified/contract price)

or estimated profit x (cash received/contract price)

The percentage of work completed can be estimated based on the following factors:

• The amount of work that has been done
• The materials that have been used
• The labour hours that have been worked
• The progress payments that have been received

The percentage of work completed can be adjusted as the contract progresses.

The percentage of completion method is the most commonly used method for calculating the profit or loss on incomplete contracts. It is a fair and accurate method that reflects the progress of the work on the contract.

Here are some of the advantages of using the percentage of completion method:

• It is a fair and accurate method of accounting for incomplete contracts.
• It provides a more realistic picture of the company’s financial performance.
• It helps to ensure that the company does not recognize profits prematurely.

Here are some of the disadvantages of using the percentage of completion method:

• It can be complex and difficult to apply.
• It requires the company to make estimates of the percentage of work completed, which can be subjective.
• It can lead to volatility in the company’s financial results.

Conclusion

Overall, the percentage of completion method is a fair and accurate method of accounting for incomplete contracts. However, it is important to be aware of the limitations of the method before using it.