Managing financials in the construction realm, particularly for long-term projects, poses quite a unique set of challenges. One widely embraced solution in the industry is the percentage of completion method, a cornerstone of construction accounting. Let’s dive into its mechanics, applications, and a sprinkle of real-life scenarios.
Understanding the Percentage of Completion Method
What exactly is the percentage of completion method? It’s a specific accounting method tailored for long-term projects which dictates that income and expenses be recognised in relation to the work completed to date. Unlike its counterpart, the completed contract method which waits until project’s end to recognize costs and revenue, the percentage of completion method allows for ongoing financial recognition, making it ideal for projects stretching over a considerable timeline.
This method not only keeps the financials ticking over regularly but also aligns more closely with ongoing work assessments and project management adaptations.
How to Calculate It: A Deeper Dive into the Cost-to-Cost Formula
Let’s say, how do we actually crunch the numbers? The most prevalent technique is the cost-to-cost basis, which involves the following calculations:
- Percentage Complete = (Total Costs Incurred to Date / Total Estimated Costs) x 100
- Revenue Recognition = Percentage Complete x Contract Total
This formula provides a straightforward way to measure the project’s financial pulse at any given time, ensuring transparency and alignment with project progress.
Real-life Scenario: Applying the Percentage of Completion
Imagine a project with an estimated budget of £100,000. Halfway through, £50,000 has been spent. This simple division indicates a 50% completion rate:
Percent complete = (£50,000 / £100,000) = 0.50 or 50%
Should the total contract be valued at £120,000, the recognised revenue at this point would be £60,000.
Potential Pitfalls
Despite its usefulness, the percentage of completion method isn’t without its risks. Differences between recognized revenues versus actual billings can lead to significant discrepancies, affecting cash flow and financial reporting. These are typically managed through precise billing adjustments and aligning ongoing project monitoring with financial assessments.
Adjusting for Project Variations and Change Orders
No project plan is immune to changes. Adjustments and change orders are a staple of construction projects, thus, recalculations using the percentage of completion method must be fluid to accommodate such variations, ensuring the accuracy of financial tracking and projections.
Conclusion
The percentage of completion method, widely utilised by general and specialty contractors alike, remains a robust mechanism for aligning project progress with financial recognition, ensuring a steady flow of revenue recognition that parallels project execution.
FAQs
- What are the primary benefits of using the percentage of completion method?
It allows for regular financial oversight, helps monitor cash flow and minimises large disparities between cost recognition and actual work completion. - Can the percentage of completion method be used for any project size?
While generally used for larger, long-term projects, its applicability can vary depending on specific business practices and regulatory requirements. - How frequently should the percentage completion be calculated?
This often depends on project complexity and duration but is typically calculated on a monthly basis. - What happens if there is a significant change in project costs?
Significant cost changes necessitate a recalculation of the percentage of completion to ensure revenue recognition remains accurate. - Are there alternatives to the percentage of completion method?
Yes, one alternative is the completed contract method, which is typically used for smaller, shorter-duration projects.