As the manufacturing industry continues to evolve, embracing new technologies and complex production methodologies, the challenge of revenue recognition becomes increasingly nuanced. Manufacturers must navigate these complexities to ensure accurate financial reporting and maintain the trust of investors and stakeholders.
The complexity of revenue recognition in manufacturing arises from factors such as long production cycles, diverse product offerings, shipping, and warranties.
Advanced revenue recognition software can be a game-changer for these businesses. Under the new revenue recognition standard set by Accounting Standards Codification 606 (ASC 606), businesses such as contract manufacturers have one unified framework for recognizing revenue.
But how does revenue recognition for manufacturing under ASC 606 actually work?
Understanding the Basics of Revenue Recognition for Manufacturers
The International Accounting Standards Board has enforced IAS 18—their accounting requirements for revenue recognition—since annual reporting periods beginning January 1, 1995.
However, when the Financial Accounting Standards Board (FASB) announced the new revenue recognition rule ASC 606, it was framed as a tool to standardize accounting and revenue recognition across industries. The rule provided a five-step process for recognizing revenue as goods or services are transferred to customers.
Revenue recognition for manufacturing can become quite complex. Transactions often involve goods produced through highly custom production processes; contracts can apply over long work periods and cover multiple milestones. A contract’s transaction price may need to account for incremental costs in addition to delivery contracts.
ASC 606 aims to streamline the process by which manufacturers recognize their revenue and maintain accurate financial statements (disclosed appropriately during annual reporting periods), which are no less critical in avoiding regulatory risks or violations.
By some estimates, more than 60% of SEC enforcement actions for financial statement fraud involve improper revenue recognition, and the manufacturing sector sees average fraud losses of more than $1 million.
ASC 606 allows businesses to follow the same clear framework for recognizing revenue. However, there are specific considerations for contract manufacturers.
Key Revenue Recognition Timing Considerations for Contract Manufacturers
Manufacturers who fulfill long-term contracts must consider revenue recognition timing strategically. They must also manage performance obligations and any required contract modifications as needed.
Let’s take a closer look at some key considerations.
Performance Obligations
Identifying performance obligations is absolutely essential for ASC 606 compliance because manufacturers can recognize revenue only after completing performance obligations.
That means that each distinct performance obligation contractually promised to a customer—whether a good, a bundle of services, or a series of these—must be identified.
Distinct performance obligations may include:
- Custom production
- Scheduled delivery or installation
- Future warranties
When manufactured goods are bundled with delivery services, the goods and services may be bundled on the same contract, but should be identified as separate performance obligations.
This will affect the timelines according to which performance obligations are made available to the customer and which revenue related to these obligations is, thus, due to the manufacturer.
Completing a performance obligation will likely lead to an enforceable right to payment, which will dictate that revenue must be recognized under ASC 606.
Point in Time vs. Over Time Recognition
An essential question as a manufacturer organizes an approach to revenue recognition is whether to recognize revenue over time or at a specific time. This decision will depend on whether a business renders goods and services in the long-term, across a series of milestones, or at once upon delivery or meeting project obligations.
In manufacturing, many custom projects are completed under a contract, with progress measured at agreed-upon milestones. However, this isn’t the only revenue recognition method.
Common Revenue Recognition Methods in Manufacturing
There are various methods to recognizing revenue for contract manufacturers, and depending on the nature of your business, you might employ one or more approaches.
- The percentage of completion method is common for customized manufacturing contracts, where revenue is recognized as progress is made, often based on the percentage of costs incurred relative to the total estimated cost.
- For contracts tied to key project stages, the milestone method allows revenue to be recognized when significant, pre-defined project milestones are achieved.
- Alternatively, manufacturers producing standard products may recognize revenue upon delivery, when control of the goods transfers to the customer.
- In some cases, the percentage of cost method is used to match revenue recognition closely with expenses, providing a clear picture of profitability throughout the project lifecycle. The choice of method often depends on factors such as how long it takes to manufacture goods, customer agreements, and the complexity of performance obligations.
When making this decision on which revenue method to choose, manufacturers should ask some key questions:
- Will a specific product be delivered, or will a defined service be performed at a particular moment?
- Will revenue be rendered throughout a service period? As the contract specifies, will it be due when a project celebrates certain milestones?
- Will a service be provided to a customer over a subscription period? Is the manufacturer providing a product continuously, following a pattern or schedule?
It’s also important to consider how a business’s spending will impact the trajectory of a project. When costs are incurred, will this affect the billing schedule?
Variable Consideration
At the most basic level, a manufacturing business produces and delivers a good to the customer. In practice, however, manufacturing contracts are rarely so simple. Discounts, penalties for goods that don’t meet quality standards, or even performance bonuses may impact the timing of revenue recognition.
Customers may also need to adjust their order sizes during the manufacturing process to ensure a reasonable profit margin.
Of course, predicting most of these adjustments in advance is challenging. Contract manufacturers should estimate potential variables reasonably to cushion themselves from financial losses.
Reporting revenue early in the process without considering such potential future adjustments may, even if unwittingly, mislead anyone reading a company’s financial statements.
Contract Modifications
Another potential moving piece? While they represent legally binding agreements between various parties, contracts can be amended becasue of purchase order quantity increase or decreases, for example.. A contract may widen (or narrow) its scope or a transaction price may shift within relevant markets.
Labor shortages, weather conditions, material supply chains, and other factors may affect production schedules. This can require manufacturers to adjust the scope of deliverables they can provide or rewrite the terms of their contracts to more accurately reflect realistic timelines. Separate contracts may also be necessary to address contingencies unforeseen in the initial agreements.
Revenue recognition contract modifications will necessarily require adjustments to the revenue schedules of these agreements, affecting the delivery or completion of performance obligations.
Customer Control and Ownership Transfer
Ultimately, revenue recognition hinges on when control of manufacturing goods will officially transfer to the customer that ordered them.
This question strikes at the heart of revenue recognition, so contract manufacturers should be familiar with different potential scenarios under which they will transfer control of their products.
Examples familiar to this industry may include:
- Consignment arrangements: A manufacturer produces goods to be sold by a customer and transfers them for this purpose, understanding that unsold products will be returned to the manufacturer.
- Staged delivery: Each separate phase or product is completed sequentially. Manufacturers deliver products to the customer as they are ready. Customers need not wait until an entire project is complete before assuming ownership of individual components.
- Subscription models: While traditionally less common in manufacturing, subscription-based approaches to manufacturing delivery and ownership transfer are increasingly popular.
Contract manufacturers should understand how revenue recognition will be affected by each decision regarding ownership transfer to the customer.
Common Challenges in Revenue Recognition Timing
Manufacturing is rarely an entirely uniform business. Each customer will want a customized product, requiring its own specialized process.
That’s why it’s so important to identify distinct performance obligations. Neglecting this aspect of the business can lead to headaches (or even regulatory risk) when it comes time to prepare financial reports.
Inaccurate estimates of variable considerations can lead to inadvertent (or negligent) and inaccurate revenue recognition. Inaccurate revenue recognition may lead to compliance issues or, at the very least, wasted time and resources to fix mistakes.
Robust accounting systems are a must, and they should be equipped to handle the multiple intricate layers of revenue recognition in manufacturing.
Best Practices for Managing Revenue Recognition Timing
The key when it comes to managing revenue recognition for manufacturing? Get out ahead of any potential problems.
Consider some best practices:
- Review contracts thoroughly line by line, identifying performance obligations.
- Use software solutions to automatically track milestones, automate progress updates, and calculate revenue recognition.
- Communicate constantly between finance, sales, operations, legal, compliance teams, and other relevant stakeholders. Make sure everyone is on the same page when it comes to contract interpretation.
- Keep detailed records of all performance milestones, delivery timelines, and estimates of variable considerations.
- Reassess as needed. Establish periodic reviews to catch changes in scope, pricing, or timing—before they jeopardize revenue recognition or demand significant revenue reversal actions.
Businesses should put a plan in place early on and stay nimble to adjust it in real-time.
How RightRev Can Help
For manufacturers, managing complex contracts, custom production processes, and variable pricing structures can make revenue recognition particularly challenging. RightRev offers tailored solutions to address these specific complexities, ensuring compliance with ASC 606 and enhancing financial accuracy.
✓ Customized Revenue Recognition Rules
Manufacturers often deal with unique performance obligations, such as custom production, scheduled deliveries, and extended warranties. RightRev allows you to define and automate revenue recognition rules for each distinct obligation within a contract. This ensures that revenue is recognized accurately and in alignment with the completion of each performance obligation.
✓ Flexible Recognition Methods
Depending on your manufacturing processes, you may need to recognize revenue at a single point in time or over a period. RightRev supports various recognition methods, including point-in-time and over-time recognition, allowing you to choose the approach that best fits your operations. This flexibility ensures that your revenue recognition aligns with the actual delivery and completion of your products and services.
✓ Handling Complex Contract Modifications
Manufacturing contracts often undergo changes, such as scope adjustments or pricing modifications. RightRev efficiently manages these contract modifications by automatically updating revenue allocations and recognition schedules. This automation reduces manual effort and minimizes the risk of errors, ensuring that your financial records remain accurate even as contracts evolve.
✓ Real-Time Revenue Insights
With RightRev, you gain real-time visibility into your revenue streams. This immediate insight allows for proactive financial management, enabling you to identify and address potential issues before they impact your financial statements. Access to up-to-date revenue data supports informed decision-making and strategic planning.
✓ Scalability for High Transaction Volumes
As your manufacturing business grows, the volume and complexity of transactions increase. RightRev is designed to handle high transaction volumes efficiently, ensuring that your revenue recognition processes remain smooth and accurate regardless of scale. This scalability ensures that your financial operations can keep pace with your business expansion.
By implementing RightRev’s automated revenue recognition solutions, manufacturing companies can streamline their financial processes, maintain compliance with accounting standards, and focus more on strategic growth initiatives. Request a demo today to see firsthand how RightRev supports contract manufacturers working to meet ASC 606 requirements.
Get Smart About Revenue Recognition
Contract manufacturing is, in the best of times, a delicate balance between efficiency, precision, compliance, and speed.
Adopting best practices for revenue recognition for manufacturing and leveraging technology like RightRev’s software to streamline compliance can help today’s business owners achieve these goals.
Taking a proactive approach to revenue recognition is efficient, visionary business leadership. Because let’s face it—you didn’t get into this business to spend your days clicking between spreadsheets.
