Cost to Cost Method
Overview of the Cost to Cost Method
The cost to cost method is used by project accountants to determine the percentage of completion of a project, and therefore the amount of revenue that can be recognized. It is an underlying component of the percentage of completion method. The formula for the cost to cost method is to divide all costs recorded to date on a project or job by the total estimated amount of costs that will be incurred for that project or job. The result is an overall percentage of completion that is then used for billing and revenue recognition purposes.
The cost to cost method is only valid if the project accountant regularly reviews and revises the total estimated project cost to verify that it remains valid, reflecting the most up-to-date cost information. If not, the method can yield incorrect results.
The cost to cost method is a favored approach by those who want to recognize the largest possible proportion of project revenues in the early stages of a project, since most of the direct material costs are incurred at the beginning of a project.
Example of the Cost to Cost Method
The Eagle Construction Company has been hired to construct a circuit board fabrication facility. Eagle has elected to purchase the materials for the air filtration system, costing $400,000, at the inception of the project. The total estimated cost of the project will be $40,000,000, and the amount billable to the customer will be $50,000,000. By the end of the first quarter of construction, Eagle has incurred $4,000,000 in costs, which includes all of the air filtration system. The $4,000,000 figure is 10% of the total cost of the project, which entitles the accounting staff to recognize 10% of the projected revenues, or $5,000,000.
A better way to handle the accounting would be to wait until the air filtration system has actually been installed, and then record the related amount of revenue. Doing so would defer the recognition of 1% of the total estimated revenue, or $500,000.