Industries that regularly deal with projects that span multiple accounting periods—construction, aerospace, engineering, etc.—face unique accounting challenges. One key issue is determining the most reliable way to recognize revenue throughout a long-term project life cycle. Generally, revenue recognition over time is preferred, but companies using this approach must also determine an appropriate way to measure project progress. One way to do this is the cost-to-cost method, which operates on the principle that the percentage of completion can be reliably measured by comparing the costs incurred to date with the total estimated costs.
What Is the Cost-to-Cost Method?
The cost-to-cost method is a technique used to recognize revenue over an extended period of time, primarily for long-term contracts or projects spanning multiple accounting periods. It’s a way to measure revenue through the lens of how much of a project has been completed, which helps provide a clear picture of a project’s financial status over time.
Unlike other methods that might measure progress by number of labor hours or units produced, the cost-to-cost method focuses solely on financial costs—specifically, by comparing costs incurred to date against total estimated project costs. Therefore, its accuracy depends heavily on precise cost estimates and tracking. Inaccurate estimates or unexpected cost overruns can lead to misstatements of revenue and profitability.
Key Takeaways
- The cost-to-cost method is used to calculate a long-term project’s percentage of completion when recognizing revenue over time.
- Cost-to-cost directly correlates revenue earned to date with actual costs incurred to date.
- Successful use of the cost-to-cost method hinges on the ability to accurately estimate total project costs and track expenses throughout the project life cycle.
- Modern accounting software with job-costing and project-tracking features can simplify cost-to-cost calculations.
The Cost-to-Cost Method Explained
The cost-to-cost method calculates project completion by assuming that costs incurred represent progress made. If a project has incurred $4 million of its $16 million estimated total costs, it’s considered 25% complete. This percentage then determines how much revenue can be recognized for the period.
Though commonly used, especially in construction accounting, cost-to-cost is just one way for companies to calculate project completion when recognizing revenue over time. Alternatives include:
- Efforts expended, which measures progress using inputs such as labor hours, machine hours, or material quantities instead of costs.
- Units of delivery, which calculates completion based on units delivered compared to total contracted units.
- Milestones met, which recognizes revenue accumulated upon achieving specific, verifiable project milestones.
The cost-to-cost method works best for industries with:
- Long-term projects spanning multiple accounting periods
- Projects with well-defined, measurable cost components
- Reliable cost estimates and tracking systems
- Project-based business models, where each project has distinct costs and revenues
However, it’s less suitable for:
- Short-term transactions with quick turnover
- Industries with unpredictable or highly fluctuating costs
- Projects where progress isn’t directly correlated with costs incurred
How to Calculate Cost-to-Cost
To calculate a project’s percentage of completion via the cost-to-cost method:
- Estimate the total expected cost to complete the project.
- Determine the actual costs incurred to date.
- Calculate the percentage of completion by dividing costs incurred to date by the total estimated costs.
- Use this percentage to determine the recognizable revenue for the period.
The formula for calculating percentage of completion using the cost-to-cost method looks like this:
Percentage of completion = (Costs incurred to date / Total estimated costs) x 100
Once the percentage of completion is determined, it’s used to calculate the cumulative revenue that should be recognized to date:
Cumulative revenue to date = Percentage of completion x Total contract price
The revenue to be recognized for the current period is then calculated as:
Current period revenue = Cumulative revenue to date – Previously recognized revenue
Example Cost-to-Cost Method Calculation
Let’s consider a construction project with the following details:
- Total contract value: $20,000,000
- Estimated total costs: $16,000,000
- Costs incurred to date: $4,000,000
- Previously recognized revenue: $0
Step 1: Calculate the percentage of completion.
Percentage of completion = (Costs incurred to date / Total estimated costs) x 100
Percentage of completion = ($4,000,000 / $16,000,000) x 100 = 25%
Step 2: Calculate the cumulative revenue to date.
Cumulative revenue to date = Percentage of completion x Total contract price
Cumulative revenue to date = 25% x $20,000,000 = $5,000,000
Step 3: Calculate the revenue to be recognized in the current period.
Current period revenue = Cumulative revenue to date – Previously recognized revenue
Cumulative revenue to date = $5,000,000 – $0 = $5,000,000
So, in this example, the construction company would recognize $5,000,000 in revenue for the current accounting period based on the cost-to-cost method.
As the project progresses, the company would regularly update its total cost estimates and adjust the percentage of completion accordingly. This ensures that revenue recognition remains accurate throughout the project’s life cycle.
Advantages of the Cost-to-Cost Method
The cost-to-cost method offers four key benefits for companies managing long-term projects. Each advantage stems from its systematic approach to measuring progress and recognizing revenue. When applied effectively, this method enhances profitability forecasting and cash flow management, and reduces the risk of revenue misstatements.
Aligns revenue recognition with costs incurred:
The cost-to-cost method ensures that revenue recognition is directly tied to the actual costs incurred during a project. This alignment provides a more accurate representation of a company’s financial performance, as revenue is recognized in proportion to the work completed. In other words, the risk of premature or delayed revenue recognition is minimized.
Improves profitability forecasting:
By closely tracking both costs and the project’s progress, the cost-to-cost method fosters more accurate profitability forecasting. Companies can better estimate future revenues, profits, and cost overruns, all based on current project performance, leading to more informed decision-making and resource allocation.
Continuous tracking aids progress measurement:
The method requires ongoing monitoring of project costs and progress, allowing for timely insights into financial and operational performance, as well as project status. This continuous tracking helps proactively identify budget deviations, enabling project managers to address cost overruns before they escalate.
Provides a more stable cash flow:
By recognizing revenue gradually throughout the project, rather than only at completion, the cost-to-cost method supports a smoother and more predictable cash flow. Cash flow stability can be particularly beneficial for companies managing long-term, capital-intensive projects, as it leads to better financial planning, resource management, and risk mitigation.
Limitations of the Cost-to-Cost Method
The cost-to-cost method provides a structured way to assess project progress, but several challenges can affect financial reporting and decision-making. These include potential inaccuracies in cost estimates, complexities in cost tracking, and sensitivity to unforeseen project changes. Recognizing and proactively addressing these limitations helps managers implement strategies to mitigate risks and improve financial accuracy. Here are some of the limitations.
Inaccurate cost estimates can impact recognized revenue:
The accuracy of the cost-to-cost method hinges on the initial cost estimates. If these estimates are off, it can lead to significant discrepancies in recognized revenue. For instance, underestimating costs could inflate early-stage profitability, while overestimations could suppress recognized revenue. Both distort financial statements and influence stakeholder perceptions.
Cost tracking can be complicated and time-consuming:
Implementing the cost-to-cost method requires meticulous cost tracking and job costing throughout the project’s life cycle, which can be complex when handling large projects with many cost components. Companies need robust systems and processes to capture, categorize, and report costs accurately for each specific job or project. The time and resources required for this level of detailed tracking can be substantial, potentially impacting operational efficiency.
Up-front cost estimation can be vulnerable to unforeseen changes:
Compared to projects completed within one or two accounting periods, long-term projects can be more susceptible to unforeseen changes, such as material price fluctuations, labor shortages, or regulatory updates. These factors can significantly alter the initial cost estimates. And because the cost-to-cost method might not immediately reflect major changes, any disconnects between reported and actual progress would necessitate reestimation and adjustment.
Potential to overestimate or underestimate progress:
The method assumes a direct correlation between costs incurred and project progress, but this assumption might not always hold true. Up-front costs (e.g., for materials or equipment) can make a project appear farther along than it really is, while later stages might see rapid progress with relatively lower costs. This misalignment can skew financial reporting and project completion status.
Risk of profit manipulation:
Since the cost-to-cost method relies on cost estimates, management can influence revenue recognition by intentionally adjusting estimates. For instance, selective inclusion—or exclusion—of certain costs in estimates can skew reported revenues and profits. What’s more, the subjective nature of cost estimates, especially for complex, long-term projects, makes it challenging for external parties to detect such manipulations without extensive investigation. Companies need strong controls and external audits to scrutinize the accuracy of cost estimates, cost-tracking completeness, and consistency in application. This involves reviews of project budgets, actual cost records, and budget revisions.
Accounting Software Simplifies Revenue Recognition
By offering a centralized platform for financial management, project tracking, and resource allocation—part of its cloud-based enterprise resource planning (ERP) system—NetSuite Construction ERP helps address many of the challenges of long-term revenue recognition. The system’s job costing capabilities directly support the cost-to-cost method by allowing for accurate tracking of labor, materials, and overhead costs throughout the project life cycle, which ensures precise calculation of costs incurred to date. Automated revenue recognition functionality makes the process even easier. The system validates compliance with accounting standards, and its cloud-based architecture gives all team members access to the kind of up-to-date information they need to facilitate insightful decision-making, ultimately improving overall project outcomes.
The cost-to-cost method is a common way for companies to determine the percentage of project completion when recognizing revenue over time. By aligning revenue recognition with actual costs incurred, the cost-to-cost method provides an accurate representation of a company’s financial performance and project status—as long as estimates are as accurate and comprehensive as possible. Robust systems and processes to support precise cost data collection and analysis are keys to success.
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Cost-to-Cost Method FAQs
What is the relationship between the percentage-of-completion method and the cost-to-cost method?
The percentage-of-completion method is a broad accounting principle for recognizing revenue on long-term contracts. The cost-to-cost method is a specific technique within this principle that measures a project’s completion by comparing costs incurred to date with total estimated costs, providing a quantitative basis for revenue recognition.
Under which circumstances would it be appropriate to use the cost-to-cost method?
The cost-to-cost method is most appropriate for long-term projects where revenue must be recognized over protracted periods of time. It’s suitable when costs reliably indicate progress and there are dependable cost estimates. Common in construction and engineering, it’s less fitting for projects with unpredictable costs.
