Thursday, May 7, 2009

Percentage of Completion - How Much Profit to Recognize?

There are different accounting methods to determine how much profit is recognized for different projects. One method of choice is the percentage of completion method. This method is most appropriate for projects where the schedule and costs are fairly predictable and as a result, the method itself is fairly simple and intuitive.

Assume a construction project with the following construction cost structure:

Year 1: $5M
Year 2: $15M
Year 3: $10M

The overall contract price is $46M.

How much profit should be recognized in each of the given years?

Firstly, the total construction cost is ($5M + $15M + $10M) or $30M. Therefore, the overall profit from the project is ($46M - $30M) or $16M. Also, for each year, the following percentage of work is completed:

Year 1: $5M / $30M or 16.7%
Year 2: $10M / $30M or 33.3%
Year 3: $15M / $30M or 50%

Therefore, the profit which should be recognized in each year is:

Year 1: 16.7% of $16M or $2.67M
Year 2: 33% of $16M or $5.33M
Year 3: 50% of $16M or $8M

This is a fairly clean method of understanding how profit for individual projects within companies should be recognized.

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