Percentage of completion method (POC): A comprehensive guide
Revenue recognition, the process of recording income when it's earned rather than when cash is received, is a critical challenge for construction companies, where projects often stretch over months or even years. The percentage of completion (POC) method offers a solution, allowing businesses to recognize revenue as a project progresses rather than waiting until it’s fully completed. It provides a clearer picture of cash flow and financial health at every stage of a project.
It also helps you track income and expenses more accurately while strengthening your ability to make informed decisions, secure funding, and maintain profitability throughout the project life cycle.
Just like enterprise accounting software, the POC method has many benefits for construction businesses. Read on to find out what those benefits are, how the POC method works, and how to incorporate it into your financial strategy to optimize performance.
Why the percentage method is important
The POC accounting method works on the principle that you should be able to track revenue in line with the project’s progress. It means that if 50% of a project is complete, you should be able to calculate 50% of the total expected revenue. As the project progresses and incurs more production costs, the percentage of completion increases, leading to a corresponding increase in recognized revenue.
Construction businesses can benefit greatly from the percentage of completion accounting method. Here are some of its benefits:
- Accurate revenue recognition: You’ll get a more accurate representation of the company's financial performance. It also helps prevent overstating or understating revenue, which can distort financial statements and mislead stakeholders.
- Improved cash flow management: You can more accurately forecast the company’s income and plan expenses, helping to improve cash flow management and reduce the risk of financial difficulties.
- Enhanced financial reporting: You can get more informative and timely financial reporting (and recognize revenue as it is earned). It will help you present a clearer picture of your company’s financial health to investors, lenders, and other stakeholders.
- Adherence to GAAP: Long-term contracts, particularly in the construction industry, typically require the POC method because it helps businesses adhere to Generally Accepted Accounting Principles (GAAP). It aligns revenue recognition with project progress, providing a more accurate financial picture.
In essence, the POC method tracks progress in real time, which can produce even deeper insights when paired with a custom ERP system.
Enterprise resource planning (ERP) solutions make it easier to predict and avoid cost overruns by streamlining resource management, cash flows prediction, and project risks assessment. Its integrated reporting capabilities provide analytics that can also highlight trends, helping you make data-driven decisions to keep projects profitable and efficient.
The percentage of completion method adjustment
Initial estimates for costs and progress are often subject to change. The percentage of completion method adjustment addresses this by requiring companies to revise revenue recognition calculations when project costs or progress estimates are updated.
When project variables change, these adjustments help you:
- Improve cash flow management: Your budgeting becomes more precise, allowing for better resource allocation and cost control.
- Enhance budgeting accuracy: You make more informed decisions about cash flow, preventing surprises and enabling proactive financial planning.
- Boost stakeholder confidence: You'll foster trust with investors, lenders, and other stakeholders, as they receive an accurate representation of project performance.
- Mitigate risks effectively: You can identify potential issues, such as cost overruns or delays before they escalate.
As your project progresses and evolves, so should your projections.
Percentage of completion vs. completed contract method
The POC method recognizes revenue and associated expenses as work progresses, providing a continuous, real-time view of your financial health. So, if your project is 50% complete, you're only recognizing 50% of the expected revenue and costs.
In contrast, the completed contract method (CCM) defers the recognition of both revenue and expenses until the project is completed. While simpler, this method can obscure a company's financial performance during long-term projects, potentially leading to less accurate interim financial statements.
Choosing POC means aligning your financial reporting with actual project progress, offering a clearer picture of profitability and cash flow at every stage.
Percentage of completion calculation methods
There are several POC calculation methods available, each suited to different types of projects and scenarios. These methods help you determine the proportion of revenue to recognize based on the project's progress. Let’s explore the most common approaches.
Cost-to-cost method
The cost-to-cost method calculates the percentage of completion based on the ratio of costs incurred to date to the estimated total costs of the project.
Cost-to-cost method formula: (Costs incurred to date / Estimated total costs) * Total contract revenue
Let’s take an example to understand this better. If a project has incurred $500,000 in costs so far, and the estimated total cost is $1,000,000, with a total contract revenue of $1,200,000, the calculation would be:
(500,000 / 1,000,000) * 1,200,000 = $600,000
This type of clear, accurate financial reporting helps businesses present their financials to ownership in a synced and seamless way.
Efforts-expended method
The efforts-expended method is useful when costs alone are not a reliable indicator of project progress. It focuses on the actual effort expended, such as labor hours, machine hours, or materials used, to calculate the percentage of completion.
For example, if a project is expected to require 10,000 labor hours and 4,000 hours have been worked so far, the project would show as 40% complete in an ERP software like Intuit Enterprise Suite (IES).
This method is ideal for projects where labor or specific tasks are the primary drivers of progress, and it can provide a more accurate reflection of completion when cost data is not as precise.
Units-of-delivery method
The units-of-delivery method comes in handy for projects with distinct deliverables, such as construction phases or specific components of a larger project. Tracking progress is simple: Evaluating how many units you’ve finished relative to the total required units.
For instance, if a project involves the construction of 10 buildings, and six are completed, the project is 60% complete. Use this method when each unit or deliverable represents a significant portion of the project’s value.
Percentage of completion method examples
Here are some real-world examples of how the percentage of completion accounting method is applied in different construction scenarios:
- Road construction: The cost-to-cost method is common here. Costs incurred to date, such as labor, materials, and equipment rentals, are compared to the estimated total project costs to determine the percentage of completion. It allows project managers to track financial performance and adjust budgets as needed.
- Building construction: Use the units-of-delivery method. For example, the number of completed floors or structural elements is compared to the total planned units. This method helps assess progress at specific milestones, ensuring that the project stays on schedule.
- Custom manufacturing: Go for the efforts-expended method. It involves evaluating labor hours worked and materials used to determine the percentage of completion. It provides insights into resource allocation and efficiency throughout the production process.
- Large-scale infrastructure projects: A combination of methods can be effective. The cost-to-cost method may apply to overall project costs, while the units-of-delivery method could focus on specific milestones, such as building completion or equipment installation. This dual approach offers a comprehensive view of project progress and helps identify potential cost overruns or delays early on, allowing for proactive management and timely adjustments.
Which companies should use the percentage of completion method?
The percentage of completion method is particularly suitable for companies involved in long-term projects with identifiable stages or milestones. This method is standard in industries such as:
- Construction: Building construction, infrastructure projects, and civil engineering
- Manufacturing: Large-scale manufacturing projects with extended production planning or cycles
- Engineering: Projects involving design, development, and construction
Also, specific service industries, such as consulting or software development, may use the percentage of completion method for long-term projects with defined deliverables.
IRS requirements
The IRS mandates that construction companies use the POC method for long-term contracts that span beyond the end of the taxable year. Here are a few things you should know:
- Companies need a dependable estimate of total project costs to calculate the percentage of completion accurately.
- The project's progress must be measurable and verifiable, often requiring establishing clear milestones or deliverables.
- Companies must maintain adequate documentation to support their revenue recognition calculations.
While the percentage of completion method is often required, certain smaller or shorter-term projects may still be eligible for the completed contract method, subject to IRS approval.
Common challenges with the percentage of completion method (and how to address them)
While the percentage of completion method offers significant advantages in terms of accurate revenue recognition, it also comes with certain risks that you should be aware of.
Inaccurate billing
Overestimating or underestimating project progress can lead to overbilling or underbilling customers. Overbilling can damage customer relationships and may result in legal consequences. Underbilling, on the other hand, can lead to lower business profitability and financial difficulties.
Your accounting team or solution should be able to:
- Implement reliable progress measurement methods: Utilize approaches like time-and-material tracking, units of delivery, or performance indicators to accurately assess project completion.
- Regularly review and adjust estimates: Continuously evaluate actual performance against initial estimates and adjust based on changes in project scope.
- Facilitate open communication: Maintain transparent communication with stakeholders about project progress, potential cost adjustments, and timelines.
From a supervision perspective, it’s also crucial to establish checks and balances to prevent the abuse of the percentage of completion method, ensuring that all progress claims are justified and accurately documented.
Change orders
Change orders can significantly impact a project's overall scope, cost, and timeline, negatively affecting financial performance. Mismanaged charge orders can lead to increased costs and delayed timelines, resulting in potential cash flow issues and budget overruns.
This can strain relationships with clients and stakeholders, as unanticipated changes may affect project delivery and satisfaction. Additionally, if revenue recognition is not adjusted accordingly, it can lead to inaccurate financial reporting, affecting the company’s profitability and decision-making processes.
Your accounting team or software should be able to:
- Track change orders in real-time: Implement a system that allows for real-time tracking of change orders, capturing their impact on scope, costs, and timelines as they occur.
- Update estimates promptly: Ensure the accounting solution can quickly revise estimates based on change orders, incorporating new costs and timelines to maintain accurate financial projections.
- Recalculate POC automatically: Use software that can automatically recalculate the POC based on updated estimates, ensuring revenue recognition aligns with the current project status.
- Generate comprehensive reports: Provide detailed reports that outline the financial implications of change orders, helping management understand their impact on overall project performance and making it easier to communicate these changes to stakeholders.
These challenges are important to consider. Still, the percentage of completion method remains a powerful tool for accurately recognizing revenue. It provides a balanced approach to financial reporting by recognizing income as work progresses, ensuring that financial statements accurately reflect the project status at any given time.
Navigate midsize and enterprise business challenges and opportunities
Successfully managing the complexities of the percentage of completion method can be a game-changer for midsize businesses, particularly in industries where long-term projects are the norm. Accurate revenue recognition and effective risk management are key to making informed decisions that drive growth.
If you're looking for a more comprehensive solution to integrate your midsize business processes, consider ERP software like Intuit Enterprise Suite.