In many businesses, recording revenue is a simple practice: the good or service is provided, money changes hands, and the sale is recorded. Maybe there’s an invoice, but even those are typically paid on net-30 terms.
But what happens if the revenue is for a long-term project? For project or contract-based businesses, this means grinding out work for months at a time without recording revenue.
These types of businesses, like construction or engineering companies, use an accounting method that amortizes revenue over the course of the project, smoothing out their sales and giving a more accurate profit measurement. This method is called the cost-to-cost method, and here’s what you need to know.
What is the cost-to-cost method?
The cost-to-cost method is used in project accounting to recognize revenue over the course of the project. It involves recording revenue based on how much of the project has been completed to amortize the entire sales amount over the project’s timespan.
In the cost-to-cost method, progress on the project is measured by the percentage of total costs incurred. This means the methodology is best suited for businesses with direct costs on projects, such as raw materials and direct labor hours.
How to calculate the cost-to-cost method
The cost-to-cost method calculation requires four pieces of information:
- Total cost estimate for the project
- Actual costs incurred
- Contract or project sales amount
- Previously recognized revenue
With this information, you can calculate the cost-to-cost method in three steps.
Step 1: Calculate the percentage of project completion
As discussed, the cost-to-cost method uses the costs incurred as a measurement of project completion. The percentage of project completion formula is:
Step 2: Calculate the cumulative revenue
Calculating the cumulative revenue requires the percentage of project completion (as calculated in step 1) and the contract or project value. With that info, use the formula below:
Step 3: Calculate the revenue to be recorded in the current period
Before recording the revenue on the books, you must account for any previously recorded revenue. This includes any down payments or prepayments received before the project began.
Tally up all previously recorded revenue and simply subtract it from the cumulative revenue calculated in step 2. Or, as a formula:
You now have the amount of revenue to record on the books for the accounting period.
How does the cost-to-cost method work
The cost-to-cost method is composed of four components.
1. Estimate total costs
To use the cost-to-cost method, you need an estimate of the total cost of the project, including the direct materials, direct labor, and any indirect costs incurred.
There are three methods typically used to estimate project costs in the cost-to-cost method:
- Analogous estimate: Use historical data from similar past projects to estimate the cost of a new one.
- Bottom-up estimate: Estimate the cost for individual tasks or components of a project, summing them up to estimate the total.
- Parameter estimate: Making a prediction based on a wide array of data points, including past projects, market trends, and labor estimates.
Keep in mind that the cost-to-cost method works best with an accurate estimate of total costs. Dedicate time to break down the costs to the best of your abilities so you can confidently estimate the project completion percentage.
2. Record expenses
As the project is ongoing, accurately record all of the expenses associated with it. This can be easier said than done, as you need a clear record of which project an expense is associated with.
It’s best to collect documents and expense reports and mark the project on the document itself. Keep these documents in a safe place so you can refer back to them.
3. Calculate the percentage of project completion
With the estimated total costs and the actual costs, you can calculate the percentage of project completion. Simply input the two values into this formula:
4. Recognize revenue
Record the amount of revenue on the books by taking the percentage of project completion and multiplying it by the sales amount for the project.
Once revenue is recorded, you need to reduce further calculations by the total revenue recorded. As an example, if you’ve recorded 25% of the revenue in Q1 and you’re at 50% of project completion at the end of Q2, you should record another 25% in Q2 (50% - 25%).
Example of the cost-to-cost method
A construction company has signed on to complete a project that’s set to take the next twelve months, with payment coming on project completion. To amortize the revenue across the year, they use the cost-to-cost method.
The value of the contract is $10,000,000. After scoping the project, the finance team has estimated that the combination of direct materials, direct labor, and indirect costs would be $5,000,000. To guarantee the project, they’ve taken a down payment of $100,000.
At the end of the first quarter, they’re set to record revenue based on the cost-to-cost method calculation.
At this point, they’ve recorded $2,000,000 in expenses. Using this and the estimated project costs, they calculate the percentage of completion:
Percentage of completion = actual costs / estimated total costs
Percentage of completion = 2,000,000 / 5,000,000
Percentage of completion = 0.40
The project is calculated to be 40% complete based on the expenses incurred to date. This is then used to calculate the cumulative revenue:
Cumulative revenue = percentage of project completion x contract Value
Cumulative revenue = 0.4 x $10,000,000
Cumulative revenue = $4,000,000
There’s one final step, which is accounting for the previously recorded revenue (the down payment).
Current period revenue = cumulative revenue - previously recorded revenue
Current period revenue = $4,000,000 - $100,000
Current period revenue = $3,900,000
For the first quarter, the business will record $3,900,000 as revenue from the project. As the project progresses, they’ll continue to update their actual costs and record the calculated revenue in subsequent quarters.
Benefits of the cost-to-cost method
If you’re a business that works on long-term projects, you should consider the cost-to-cost method for these reasons.
Accurate revenue recognition
Rather than recording revenue when payment is received, revenue recognition is tied to project completion. Instead of a bulk revenue amount, the money is amortized over the course of the project, reflecting the work being done.
This approach provides businesses with a clearer picture of the revenue earned in a specific period. This is especially important for businesses that may have just a single project on the go—they would otherwise record zero revenue on the books unless a payment was received.
Improved forecasting
Having bulk deposits on the books historically makes it difficult to forecast the future. When you smooth that revenue over the project’s lifespan, you get better revenue data to create financial forecasts from.
This gives businesses more accurate information to create budgets, allocate resources, and make investment decisions. Overall, it’ll be easier to set targets and maximize profitability.
Reduced profit volatility
Consider a project with $100,000 in costs incurred each month, with payment coming at the end of six months. The business would report a net loss of $100,000 (plus operating expenses) for each month, only showing a profit in that final month.
With the cost-to-cost method, the business can understand how it’s trending profit-wise. The reduced profit volatility helps create a clearer picture of its financial performance.
Early revenue recognition
The cost-to-cost method is favored by businesses that incur a large amount of the project costs early on in the project. For example, if the business buys all of the materials at the start of the project, it would use the cost-to-cost method to recognize a large percentage of revenue early.
Early revenue recognition bolsters financial performance, demonstrating growth in the business. It can also be helpful when applying for credit or looking for an investment.
Cons of the cost-to-cost method
The cost-to-cost method doesn’t come without its challenges. These are some of the most common pain points to avoid when using the cost-to-cost method.
Accurate cost tracking
The cost-to-cost method of revenue recognition is only as accurate as a business’s expense tracking. Missing costs, misattributed expenses, or imperfect estimations can throw off revenue recognition, leading to misleading financial statements.
Overestimating the costs incurred leads to high revenue recognition, painting an overly rosy picture. Or if the costs are underestimated, the business may appear to be in dire straits when that’s not the case.
Changes in project scope
If the scope of the project changes, the estimated project cost may change too. Simply put, the project needs to be predictable for the cost-to-cost method to be effective.
As an example, the customer may want something redone or change the specifications of the project. This could potentially throw off the past revenue recognition or the ability to estimate the project completion percentage.
Unpredictable cost volatility
At the start of the cost-to-cost method is estimating the total costs of the project. But what if the unit prices change? Maybe the cost of labor increases, or the costs of the raw materials have gone down.
As the unit costs of the inputs shift, so too does the estimate of the total project costs. The longer-term that a project is, the more likely the costs will change throughout its course.
Time requirement
Every step in the cost-to-cost method requires time and effort from everyone involved in the project. There needs to be a total cost estimate, expense tracking, and accurate, up-to-date reporting.
Large projects become increasingly complex and require diligent recordkeeping. This is especially true when multiple projects are going on at the same time, and certain expenses may be used across all ongoing work.
Businesses need robust and scalable systems for project costing and expense tracking to use the cost-to-cost method efficiently. Remember that it’s a process that needs to be done repeatedly—a painful experience once will have to happen again.
Automate cost-to-cost recognition
The pain points of the cost-to-cost method can be mitigated with automation and effective expense management strategies.
Automating expense reconciliation ensures that the numbers on the books are accurate and up-to-date. Saving time and guaranteeing confidence streamlines calculating the project progress percentage with accuracy.
Additionally, the use of virtual cards or corporate cards help keep project costs clean and organized. Have a single card dedicated to all of the project costs, and you’ll have a running tally you can rely on without manual calculation.
Use these solutions in tandem, and you have an automated and accurate way to track project costs and perform the cost-to-cost method calculations with confidence.
That’s why construction companies turn to BILL to help manage their project costing. Our automated expense reconciliation and virtual cards give project-based companies complete visibility into their job costing without increasing their workload.
“What used to take 90 hours a month, takes 2. Card users get a notification, take a picture of their receipt from the app, and we’re able to close the books. With BILL Spend & Expense, click some buttons, you’re done." - James Streeter, AP Manager of Westland Construction
Request a demo to see the platform and how automation can give you better results without the manual work.
