In the complex and sometimes chaotic world of long-term construction projects, many contractors find themselves struggling to accurately align the revenue coming in with the expenses being paid out. This is where the percentage of completion method of accounting often comes in handy. When executed properly, it offers a real-time reflection of income and costs in close alignment with a project’s life cycle.
Generally, the percentage of completion method is used when: 1) a job will likely take at least two years to complete from the contract’s start date, 2) revenue collection is reasonably expected to occur without disruption, and 3) project progress and completion are reasonably expected to be measurable and achievable.
This widely used accounting method is among the most accurate ways to recognize revenue from long-term projects, and it can help ensure those jobs remain financially viable by splitting tax-reporting obligations for them over the multiple years involved.
How it works
Under the percentage of completion method, rather than waiting until a job is finished, the construction business invoices in stages (monthly is typical) for work performed to date and records the earned revenue and expenses at each stage. Doing so not only better maintains accuracy, but also tends to please other project stakeholders because of its precision.
The method becomes particularly advantageous when construction companies encounter projects that become delayed or stopped completely. By recognizing revenue in stages, contractors can bill and (one hopes) obtain payment for work already executed, mitigating the financial risks associated with delayed or incomplete projects.
Methods to consider
Construction businesses can measure percentage of completion in several ways. Each approach comes with its own advantages and complexities. The optimal choice will depend on factors such as the nature of the job and how accurately the project’s costs can be estimated. Here’s a brief summary of each:
Cost-to-cost method. Among the most widely used methods, cost-to-cost divides the total contract costs incurred to date by the estimated total contract cost. The resulting ratio represents the percentage of total contract revenue that has been earned so far. This method is especially beneficial when you need to buy a substantial portion of materials at the project’s outset. By applying the cost-to-cost method, you can front-load revenue recognition, capturing the largest portion of project revenue in the job’s early stages.
Efforts-expended method. Another viable approach, this method compares the actual effort expended to date with the estimated total effort required for the project. You can base the calculation on various parameters — such as direct labor hours, materials consumption or machine hours — depending on the job’s scope and dynamics. The efforts-expended method provides a nuanced perspective that accounts for the intensity of labor or resources invested at each stage of the project.
Units-of-delivery method. This approach takes a distinctive route by calculating revenue and cost based on the number of units delivered to the customer as compared with the total units specified under the contract. The units-of-delivery method is particularly relevant for jobs that focus on milestones. By tying revenue and cost to actual units delivered, you can derive a percentage of completion directly linked to demonstrable project progress.
Along with tightly aligned revenue and expenses, other upsides often accompany use of the percentage of completion method. For example, it can facilitate timely decision-making for project managers. Because jobs are accounted for in stages, your project managers may be able to better identify operational bottlenecks, such as cash flow issues or labor shortages, and update cost estimates throughout the job.
In addition, as mentioned, the percentage of completion method tends to clarify financial reporting to the extent that it builds confidence in external project stakeholders. Banks, other lenders, investors and sureties are often inclined to more generously support a construction business with sound, well-documented accounting practices.
Job well done
To be clear, the percentage of completion method isn’t the only accounting method applicable to long-term projects and may not be appropriate in every case. But it can do the job quite well under the right circumstances. Please contact our firm for help choosing the right method and applying it.