Companies undertake projects that span over various periods. When preparing financial statements, they must determine the percentage for the completion of these projects. Companies can use several methods to establish this ratio. One of these methods is called cost-to-cost.
What is the Cost-to-Cost Method?
The cost-to-cost method, or the percentage of completion method, is an accounting approach used in long-term projects and contracts, particularly in industries like construction and manufacturing. This method enables companies to record revenue and expenses as a project progresses, providing a more accurate representation of financial performance over time.
In this method, project costs, including direct materials, labour, and associated overhead, are accumulated as the project advances. The crucial element is determining the percentage of completion, usually based on the ratio of incurred costs to the total estimated project costs. Revenue and expenses then get recognized in proportion to the project’s progress.
How does the Cost-to-Cost Method work?
The cost-to-cost method is a systematic accounting approach used primarily in industries with long-term projects, such as construction and manufacturing. Its core principle involves recognizing revenue and expenses in proportion to the project’s completion over time. In practice, as a project advances, the company accumulates costs directly associated with that project, including materials, labour, and relevant overhead expenses.
It estimates the total project costs, which serve as the denominator in calculating the percentage of completion. The numerator, the cumulative costs incurred to date, is divided by this estimate to determine the completion percentage. This percentage drives the recognition of revenue and expenses on the income statement.
How to calculate the percentage of completion using the Cost-to-Cost Method?
The calculation of the percentage of completion using the cost-to-cost method is a fundamental aspect of accounting for long-term projects. This method helps companies recognize revenue and expenses as a project progresses, providing a more accurate representation of financial performance.
Companies must compare the cumulative costs incurred on the project up to a specific date to the total estimated project costs to calculate the percentage of completion. The formula for this calculation is straightforward:
Percentage of completion = (Cumulative costs incurred to date) / (Total estimated project costs).
This calculated percentage reflects how much of the project’s total costs have been incurred or how much of the project is complete. It guides the recognition of revenue and expenses in line with the project’s progress. As costs accumulate and the percentage of completion increases, more earnings, and expenses are recognized.
Example
Red Co. is working on a construction project with an estimated total cost of $1,000,000. After six months, they have incurred $400,000 in project-related costs. Red Co. uses the cost-to-cost method to calculate the percentage of completion for the project. The company uses the following formula to do so.
Percentage of completion = (cumulative costs incurred to date) / (total estimated project costs)
Percentage of completion = ($400,000) / ($1,000,000)
Percentage of completion = 40%
After six months, Red Co.’s project is 40% complete. It will recognize 40% of the total project revenue and expenses on its financial statements to reflect the progress in its accounting records.
Conclusion
The cost-to-cost method allows companies to determine the percentage of completion for a project. This approach is relevant in many industries where companies undertake various projects. In accounting, the cost-to-cost method can be crucial in determining the costs and revenues recognized in a period. Calculating the percentage of completion under this method is straightforward.
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