For most companies, the right time to recognize revenue is upon the completion of pre-determined performance obligations. When you have an extended contract or project that won’t be completed during a singular accounting cycle, however, you’ll need to employ a different method of revenue recognition for the period.
That’s where the cost-to-cost method comes into play. This method recognizes revenue in line with your progress on a project during a singular accounting period.
Cost-to-cost is an essential accounting strategy for any performance obligation that may take years (or even decades) to recognize its revenue across multiple accounting periods.
Let’s explore the use cases, Generally Accepted Accounting Principles (GAAP), and implementation steps guiding the cost-to-cost method so you can leverage this essential revenue recognition strategy for your next project.
Understanding the Cost-to-Cost Method
The cost-to-cost method is a form of the percentage of completion revenue recognition principle. Percentage of completion is an accounting method generally used on construction contracts and similar projects that span an extended length of time.
Essentially, the percentage of completion recognizes revenue concerning the amount of a project you’ve completed within a given accounting period. Percentage of completion offers a viable alternative to other accounting procedures such as:
- The completed contract method: The CCM defers all revenue recognition until project competition.
- The installment method: The installment method recognizes revenue when cash is received from the customer, regardless of the stipulations of your contract.
Since these methods can make it unclear to owners and investors when revenue will come in, most construction projects employ the more reliable cost-to-cost method. This method is also commonplace in aerospace, defense, and other industries, where contracts often unfold over several years.
How the Cost-to-Cost Method Works
The cost-to-cost method gauges the expenses you’ve incurred during an accounting period in relation to the total estimated costs of the project. To calculate it:
- Estimate the total expected cost to complete the project.
- Determine your percentage completed. To do so, divide your costs incurred to date by the estimated total costs expected for the project.
- Subtract any revenue you’ve previously recognized from the contract price.
- Multiply this figure by your percentage completed to calculate revenue for a given accounting period.
Expressed as a formula, the cost-to-cost method looks like:
Revenue = (cost incurred to date / estimated total costs) x (contract price – revenue previously recognized)
For instance, if a contract is valued at $20,000,000, your costs are $10,00,000, and the total expected net revenue is $10,000,000 over four years, the calculation for completing a quarter of the project in year one would be:
- Revenue = (2,500,000/10,000,000) x (20,000,000-0)
- Revenue = (.25) x (20,000,000)
- Revenue = 5,000,000
- Revenue = (.25) x (20,000,000)
For construction and similar industries, you should constantly calculate the costs you incur over an accounting period. This leads to more accurate management and financial statements and allows you to recognize revenue at a moment’s notice. Additionally, you need to constantly update your estimated cost to complete each project so that your revenue recognition adjusts with each changing variable.
Benefits of the Cost-to-Cost Method
Utilizing the cost-to-cost method in favor of more sporadic, infrequent revenue recognition techniques offers the following benefits.
Accurate Progress Measurement
When you recognize revenue using the cost-to-cost method, you must closely monitor your project progress and expenses. Fortunately, this helps improve accounting and progress assessment accuracy.
Regular, periodic revenue recognition on a set, recurring date means a year (or however long your accounting period is) of keeping meticulous records, gross receipts, and more. Alternatively, other revenue recognition models that align attribution with key events (such as project completion) don’t require you to keep close day-to-day tabs on your progress.
Revenue Recognition
Revenue recognition is faster when you have all the pieces in front of you. As you’ve been tracking progress throughout your accounting period, there’s no need to scramble to determine incurred costs, actual revenue realized, and other key recognition figures.
Plus, the cost-to-cost method complies with IFRS 15 and ASC 606 regulations (for more on revenue recognition standards and GAAPs, consult our ASC 606 Revenue Recognition Guide).
Project Management
Every firm seeks to meet project deadlines and cost estimates, but that’s often easier said than done. Well over 90% of construction projects go over budget on:
- Timeline
- Costs
- Both
Using the cost-to-cost method, however, forces you to closely monitor your labor hours, contract costs, and other expenses to calculate revenue. This lets you stay within budget better, as you’ll quickly notice when one factor is eating up too much of your expected revenue.
Challenges and Limitations
While cost-to-cost is an effective method for recognizing revenue during long-term projects, it’s not without its challenges. Consider the following factors if you plan on using cost-to-cost in your business.
Estimating Total Costs
As mentioned, over 90% of construction projects go over budget. Companies want their quotes to be enticing and competitive, so they’re incentivized to estimate lower final costs and tack on extra expenses as the project develops.
If possible, be as accurate as possible when giving a potential customer a quote. Even when submitting bids slightly higher than your competitors, assure them that you’re transparently laying out your full transaction price upfront and won’t surprise them with hidden costs down the road.
Additionally, no matter the quoted costs, it is imperative that the internal revenue calculations take into account the actual estimation of cost to complete the project. Lowering the profit margin on a project should not impact the revenue recognition percentages used each period for financial reporting.
Cost Variability
Signing multi-year contracts requires accounting for myriad variables. During any project, you may experience severe fluctuations in the prices, including for:
- Labor
- Materials
- Permits
- Taxes
Generally, prices only go in one direction: up. So, when planning out your long-term project, do your best to forecast the future prices of your projected expenses and account for them within your initial quote. Sizable increases in a large expense may even throw off your revenue recognition for a given period—so be sure to adjust your reported costs in such cases.
Documentation and Tracking
Keeping tabs on your labor costs, material expenses, and more is essential for accurate reporting—but it’s also difficult, time-consuming, and potentially costly. You’ll need a reliable employee (or team) who can calculate revenue recognition—or software that can automate your process.
Implementing the Cost-to-Cost Method
If you’re considering the cost-to-cost method for your revenue recognition process, be sure to think about the following:
- Fit: Is your project long-term? Is it possible to calculate costs on a cyclical basis?
- Accuracy: The accuracy of all your figures in the cost-to-cost method relies on your correct estimated costs. If you can’t accurately forecast costs for a longer project, consider utilizing a different recognition technique.
- Adjustments: If your initial projections for estimated costs or other factors are off, you must be willing and able to update the books on the fly as your project progresses.
Accounting teams should be tuned to long-term forecasting and pay special attention to the rising labor and materials prices when preparing for multi-year cost-to-cost analyses. Likewise, they should employ a robust accounting automation solution that can support a variety of revenue recognition methods.
Simplify and Automate Cost-to-Cost Recognition With RightRev
Cost-to-cost recognition keeps close tabs on your expenses, accurately measures your project’s progress, and gives your company a reliable, recurring revenue stream across multi-year projects. Keeping the kind of close records that cost-to-cost requires, however, can be quite a strain on your accounting department.
That’s why you should rely on RightRev for your cost-to-cost analyses. RightRev supports various percentage of completion recognition methods and can simplify recognizing revenue at a glance—whether you use cost-to-cost or another standard. Request a demo today and start recognizing revenue regularly, no matter how long your projects last.
