Recognizing Earnings Accurately
Using the Percent Complete Method to Smooth Revenue Fluctuations
Businesses selling customized, high-value products or services can smooth out large swings in revenue by using the percent complete method for revenue recognition.
A company selling big-ticket products and services customized for the buyer typically receives just a few orders per year, but for large dollar values. A yacht building company, a custom homebuilder, or a custom software developer are examples.
If you have such a company, you may already know that when huge sales are booked only a few times a year, it can produce enormous swings in reported revenue depending on how you customarily recognize earnings.
These fluctuations on your profit and loss statement may cause complications when seeking a loan or credit, but far more importantly, they make it difficult for you to manage your business well.
Erratic income means your P&L will show several months of red ink, and an occasional month with spectacular profits. This makes it challenging to determine on a month-to-month basis whether you’re doing well or heading for the poor house.
In such a situation, the percent complete method for recognizing revenue is an excellent means not only for smoothing earnings, but also for seeing much more accurately whether the business is profitable month to month. This method is recognized under Generally Accepted Accounting Principles, so there’s no risk using it if applied properly.
Percent complete is not difficult to understand and apply. To illustrate, consider this hypothetical example.
Mr. Wealth places an order for your top-of-the-line, fully custom $500,000 motor coach. He puts up a $150,000 deposit, promises to pay an additional $150,000 when the interior is ready to be outfitted (in about 4 months), and will make the final $200,000 payment on delivery (in about 8 months.)
Your budget to actually build the coach is $300,000. In the first month after the order, you spend $60,000 acquiring materials and components for construction, which is 20% of the total cost. So in the first month you recognize 20% of the purchase price, or $100,000, as earned income on your P&L.
The second month you spend $30,000 in labor assembling the frame (10% of the budget). That month you’ll book 10% of the sale ($50,000) on your P&L. This procedure continues until you complete the work.
As you progress, your estimate of the cost to build the coach will probably change. This will affect revenue recognition commensurately. For example, if six months into the project you realize it’s only going to cost $280,000, then you’ll suddenly be much farther along than you previously admitted. It’s permissible to recalculate how much revenue you should have recognized so far, and to catch up by recognizing the additional revenue that same month.
Of course, it also works the other way around. If you discover your costs are going to be higher, you will have over reported income in prior months. You’ll need to adjust your revenue in the current month to make up for the difference.
Not only does this method smooth out earnings, it also properly apportions earnings to the months when you have corresponding costs. This helps you monitor whether your gross margin (the difference between your cost and the selling price) is sufficient to cover your operating expenses.
Using the percent complete revenue recognition method, if you encounter consecutive months of red ink it’s a clear warning sign that your fixed expenses are not in line with sales or gross margins. This gives you a head-start in identifying specific problems and correcting course before things get out of control.
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