Cost to cost method definition

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What is 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 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, when they are purchased in advance and positioned at the job site.

How to Calculate the Cost to Cost 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.

Problems with the Cost to Cost Method

While the cost to cost method is widely used, it has several potential problems to be aware of. They are as follows:

  • Accuracy of cost estimation. The accuracy of the method heavily depends on reliable cost estimates for the entire project. If total costs are underestimated or overestimated, the reported revenue and profits will be distorted. This can lead to premature revenue recognition or delays in recognizing legitimate earnings.

  • Requires adjustments for scope changes. Long-term projects often experience changes in scope or unexpected complexities, which can increase costs beyond initial estimates. These adjustments can require recalculations, complicating financial reporting and potentially leading to revenue misstatements.

  • Subjectivity in cost classification. Determining which costs are directly attributable to the project (e.g., material and labor) versus indirect costs involves judgment. This can lead to inconsistencies and the potential manipulation of revenue recognition.

  • Adverse impact of cost overruns. Unexpected cost overruns directly affect the percentage of completion, potentially reversing previously recognized revenue or profits. This creates volatility in financial statements and makes performance tracking more complex.

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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.