The Percentage of Completion MethodDefined with Examples

Typically, you recognize revenue when you earn it and revenue recognition is typically easier to track for the sale of goods.

In a nutshell, you earn revenue when the ownership of the goods is transferred to the customer.

Let’s use a simple example to help illustrate this concept: imagine that you own a convenience store, when the customer pays for the product, a sale is made and that is when revenue is earned and recognized.

For the sale of service on the other hand, it may not be as straightforward as there are several methods of service revenue recognition.

However, service is considered earned when it is fully rendered or performed.

For example, Anna owns a business that offers cleaning services.

A customer employed her services to help with an after party clean-up.

In such a scenario, revenue is only recognized when the service is fully performed.

As such, when Anna completes her cleaning services, that’s the time when she earns and recognize revenue.

That is how it usually goes for services that can be completed within a period.

But how about services that can span over several periods such as construction projects?

Does the rule “service is earned when it is fully rendered or performed” still apply?

Suppose that a business currently only has projects that span for three or more years.

Does that mean that the business can only recognize revenue after three years or so when construction is completed?

Fortunately, that is not the case.

There is a specific method of revenue recognition that applies to such cases.

It allows businesses that perform long-term services to recognize revenue in every accounting period.

This is called the percentage of completion method.

In this article, we will be discussing what the percentage of completion method is.

We will also be discussing the steps to calculating the revenue to be recognized using this method.

Let’s get started!

The Percentage of Completion Method Defined

The percentage of completion method is one of the several methods of revenue recognition.

Under the percentage of completion method, revenue (and its corresponding cost) is recognized in each period that the project/contract is live.

The amount of revenue to be recognized is based on how far along the project is from its completion.

Aside from recognizing revenue, it also allows the business to recognize the costs related to the project that were already incurred.

The percentage of completion method allows businesses that have long-term projects to recognize revenue in every period that the project is live until completion.

This is in contrast to the usual method of revenue recognition (completed contract method) which only recognizes revenue when the service is completed.

With this method, any business won’t have to worry about having accounting periods where no revenue is recognized (as long as there is a live project).

The percentage of completion method also facilitates the spreading of the tax burden over several periods.

This benefits both the business and the IRS.

The business benefits by having a lighter tax burden.

Meanwhile, the IRS benefits by securing annual tax remittances from the business.

For this method to be as accurate as it could be, certain conditions must be met:

• Collection of payment for the project is reasonably assured
• Estimates for project cost as well as the percentage of completion can be reasonably made

The absence of the above conditions might cause computations to be inaccurate.

In summary, the percentage of completion allows a business to recognize periodic revenues and costs from its long-term projects.

The amount to be recognized is based on how far along the project is in regards to completion.

It also allows the business to spread its tax burden over the periods that the project is live.

Calculating Revenue using the Percentage of Completion Method

Using the percentage of completion method for revenue recognition can be quite daunting at first.

It does not follow the usual revenue recognition format (completed contract method).

However, once the conditions have been met, it’s really not that difficult.

Here are the steps to take when using this method:

Step 1. Determine the percentage of completion

The first step is to determine the percentage of completion.

This method of revenue recognition cannot be initiated without it.

There are three ways to determine the percentage of completion: the efforts-expended method, cost-to-cost method, and units-of-delivery method.

These three methods will be discussed further in this article.

Step 2. Calculate the revenue to date

The next step is to calculate the revenue to date.

By that, it means that we need to determine the total revenue to be recognized at the current stage of the project.

This can be done by multiplying the total estimated revenue of the project by the percentage of completion.

For example, if the percentage of completion is at 75% and the estimated total revenue is $100,000, then the revenue to date is $75,000.

Step 3. Calculate the revenue to be recognized for the current period

The last step is to calculate the revenue for the current period.

If it is at the first year of the project, this step is unnecessary because the revenue to be recognized is equal to what we computed from step 2.

From the second year onward, the revenue to be recognized can be determined by subtracting from the figure we got from step 2 any revenue that’s already recognized from previous periods.

For example, we gathered from step 2 that the revenue to date is $75,000.

Assuming that $55,000 of revenue was recognized from previous periods, then the current period revenue is $20,000.

(Note that these steps can also be used for the recognition of costs related to the project.

Instead of using the revenue figure, you instead use the total estimated cost figure.)

Determining the Percentage of Completion

The percentage of completion method cannot be initiated if you cannot determine the percentage of completion.

There are three methods in which you can determine a project’s percentage of completion.

These are the following:

Efforts-expended Method

Under the efforts-expended method, the percentage of completion is computed by comparing the effort already expended to the total expected amount of effort required.

“Effort” could be quantified using certain variables such as labor hours, machine hours, or the quantity of materials consumed.

For example, a project could be estimated to be completed by rendering 40,000 labor hours.

To calculate the percentage of completion, the following formula can be used:

Percentage of Completion = Efforts already expended ÷ Total Estimated Effort

For example, let’s say that you own a business that does construction services.

Your business was contracted to complete a 3-year project.

It is estimated to take 22,000 direct labor hours to complete.

At the end of the year, 8,000 direct labor hours were rendered.

To determine the percentage of completion, we use the above formula:

Percentage of Completion = Efforts already expended ÷ Total Estimated Effort

= 8,000 ÷ 22,000

= 0.3636 or 36.36%

At the end of the year, the project is estimated to be 36.36% complete.

This percentage of completion will then be used for the computation of revenue to be recognized.

Let’s say the project is estimated to cost you $800,000 with an assigned gross profit margin of 20%.

That means that you expect to receive $960,000 in total for the completion of the project.

To determine how much revenue must be recognized at the end of the first year, we multiply the estimated revenue by the percentage of completion:

$960,000 x 36.36% = $349,090.91

Cost-to-cost Method

The cost-to-cost method is similar to the efforts-expended method in that it compares the incurred cost to date to the estimated total cost of the project.

This is a method in which the revenue to be recognized is determined by the cost already incurred.

To determine the percentage of completion under this method, the total incurred cost to date is divided by the estimated total cost.

Put into formula form, it should look like this:

Percentage of Completion = Cost Incurred to Date ÷ Estimated Total Cost

The cost of items already purchased but are yet to be installed is not included in the computation of cost incurred to date.

The exception is that if it is explicitly stated in the contract that it must be included.

The cost of the equipment must also be allocated over the contract period unless the title to it is transferred or being transferred to the customer.

For example, a project is estimated to have a total of $2,000,0000.

By the end of the year, a total of $1,200,000 cost has already been incurred to date.

To determine the percentage of completion, let use the formula above:

Percentage of Completion = Cost Incurred to Date ÷ Estimated Total Cost

= $1,200,000 ÷ $2,000,000

= 0.60 or 60%

As of the end of the year, the project is 60%.

This is the percentage of completion.

Let’s say that the estimated revenue of the project is $3,000,000.

It is already the second year of the project.

$800,000 was already recognized from the previous year.

Let’s determine the revenue to be recognized for the current year.

But first, we need to determine the revenue to date.

We can get it by multiplying the estimated revenue by the percentage of completion:

$3,000,000 x 60% = $1,800,000

Now that we have our revenue to date, we can calculate the revenue for the current period.

This can be done by subtracting from the revenue to date the revenue already recognized from previous periods:

$1,800,000 – $800,000 = $1,000,000

Units-of-Delivery Method

The units-of-delivery method is suitable for projects that depend on the delivery of specific units.

Under this method, the actual number of units delivered is compared to the number of deliverable units specified in the contract.

Of the three methods, this is more likely to produce accurate results.

The trade-off is that it should only be used for projects that specify the number of units to be delivered.

To determine the percentage of completion under this method, we need to divide the number of units delivered over the total number of deliverable units.

Put into formula form, it should look like this:

Percentage of Completion = Number of Units Delivered ÷ Number of Total Deliverable Units

For example, your business was contracted to build a 300-home subdivision.

At the end of the year, 90 homes have already been completed.

We compute the percentage of completion by using the formula:

Percentage of Completion = Number of Units Delivered ÷ Number of Total Deliverable Units

= 90 ÷ 300

= 0.30 or 30%

This means that the project is 30% complete.

If the project is estimated to have a total revenue of $6,000,000, then the revenue to date would be:

$6,000,000 x 30% = $1,800,000

Alternatively, you can use the contract price of each delivered unit for the recognition of revenue.

Assuming that each unit has the same contract price, we can divide the estimated revenue by the number of deliverable units:

$6,000,000 ÷ 300 = $20,000

Each home is estimated to have a contract price of $20,000.

Multiply that by the actual units delivered, we get a revenue of:

$20,000 x 90 = $1,800,000

Benefits and Limitations of the Percentage of Completion Method

Benefits of the Percent of Completion Method

Assuming that a business is qualified to use the percentage of completion method, here are the benefits that it brings:

• It allows the business to recognize revenues and costs in every period that the long-term project is live; this is in contrast to recognizing them all after the project is completed
• It only recognizes cost that is proportionate to the percentage of completion; as such, the business won’t have to worry about overstating costs; this also allows a more real-time estimate of the revenues and costs related to the project at a specified time
• It allows the business to lighten its annual tax burden by spreading it over the years that the project is live

Limitations of the Percentage of Completion Method

The percentage of completion method enables a business to recognize revenue in a non-typical way but it has its limitations:

• This method is only applicable for contracts/projects that span over more than one accounting period; while it can be used for short-term projects, it is inefficient and only adds more work to the accounting department; for short-term projects, the completed contract method is still the preferred method of revenue recognition
• Due to the nature of long-term projects spanning over several years, estimating the costs and revenues associated with them can be difficult; it is especially apparent at the start of the project where not much information can be gathered yet
• Since cost and revenues are estimated at the start of the project, there is a chance that they are inaccurate; to remedy this, the total estimated costs and revenues must be periodically reviewed; this will make it so that they accurately reflect the state of the project