What is percentage of completion method?
It is one of the revenue recognition methods in accounting to measure and record the revenue from long-term contracts. It is different from the basic revenue recognition principle. This method is typically used in the scenarios where the costs are recorded on a proportional basis, revenue collection is assured. Also, to maintain the consistency and relevancy the revenue and costs related to the period are recorded in the same period. here we will discuss the percentage of completion method.
So in short whenever there are long term contracts, the estimated revenue and costs are split across the length or the duration of the project. Now as time goes by and the project makes progress towards completion, the revenue and costs for the period are recorded into the accounting books on pro-rata basis. Of course, recognition of revenue is subject to the probability of the collection of the revenue. This type of accounting method is mainly used in construction projects as the length of the project is long and the costs and revenue need to be tied up together based on the completion of the project.
Components of percentage of completion method
Following are the components of the percentage of completion method:
- Cost-to-cost method
In this method, the only cost of the raw material and equipment purchased and used in the project is used in the calculation of the revenue recognized for the period. If something is purchased but not used in the project as of now will not become a part of the calculation.
- Efforts expended method
In this method, the cost is calculated in terms of the efforts instead of raw material purchased and used in the project. So the efforts expended to till date with respect to the total estimated efforts for the entire project is used in the calculation of the revenue recognized for the period.
- Units-of-delivery method
In this method, the revenue for the period is recognized to the extent of the units delivered to till date with respect to the estimated units to be delivered for the entire length of the contract. So the units delivered to till date is used as a metric for calculating the recognized revenue on a pro-rata basis.
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All these variations use different metrics to calculate the revenue for the period but the underlying logic is still the same. To simplify the following are the main inputs for the calculation for the revenue for the period:
- Estimated total cost for the entire duration of the project or contract
- Estimated total revenue for the entire duration of the project or contract
- The cumulative cost of the project incurred as of present
- Cumulative revenue recognized from the project as of present
Carrying out simple mathematics based on the above components can provide the revenue to be recognized for the current period. Though it may not provide the exact realistic figures this seems to be the most possible way to accurately measure the revenue from the long term contracts in the most probable manner.
Formula of percentage of completion method
Following formula can be used to calculate the revenue to be recognized for the period based on the percentage of completion method:
m = the number of periods lapsed since the inception of the contract.
N = the expected length of the contract
K = the current period
E = the total estimated cost of a contract
Let us take a simple example of a construction project to show how the revenue and costs are recognized for a particular period after some interval.
Let us assume a corporation got a long term construction contract. The project is estimated to run for 5 years and will cost approx. $10 million (approx. estimate) and the total revenue is estimated to be approx. 200 million. Let us say it is the end of the first year and the cost incurred till now is $2000. So the revenue recognized will be calculated as follows:
Let’s say in year 2 due to some unforeseen circumstances the project’s total cost is recalculated to $12 million. Also, the cost incurred so far is $6 million. So the revenue recognized will be calculated as follows:
Following are the advantages of the percentage of completion method:
- It allocates the cost and revenue pertaining to a particular period based on the extent of completion of the contract or project and hence there is no need to wait till the project is completed to recognize the cost and revenues incurred in the duration of the contract or project.
- It does not allocate the proportion of cost that is incurred but is not currently put to use in the project. Hence it gives a more real-time estimate of the costs and revenues associated with the project.
Following are the disadvantages of the percentage of completion method:
- Since construction projects take a long time to complete, the estimation of the costs and associated revenues is a daunting task as not much information is available at the start of the project.
- If the initial estimate of revenue and costs for the project are not accurate then there may be changes and adjustments to them quite frequently which may show fluctuation in the revenue and costs realized in the accounting books. This will not reflect a good picture in front of the stakeholders of the company.
Following are the limitations of the percentage of completion method:
- This method can only be used for contracts which have a duration of more than one year.
- This method may show fluctuation in the estimates given by the management.
- There are three types of variations that can be used under the percentage of completion method: Cost-to-cost method, Efforts expended method and Units-of-delivery method.
- This method holds good only in specific circumstances (like long duration contracts).
- This method must be used only when revenue and costs associated with the project can be estimated with high accuracy to avoid multiple adjustments to the estimates.
This has been a guide to the Percentage Of Completion Method. Here we have discussed the components, formula, example, advantage, and disadvantages of a percentage of completion method. You may also have a look at the following articles to learn more –