What Is the Cost Recovery Method? With Definitions and Example
Is yours a business that sells goods on credit?
Trying to find a conservative method of revenue recognition?
This is the page for you!
In case you are facing a doubtful situation regarding collection of your receivables, then the Cost Recovery Method could be the solution you are looking for.
Read on to reach the depths of the Cost Recovery Method. Here is what more you can learn:
- What is the Cost Recovery Method?
- What is meant by Revenue Recognition?
- When to Use the Cost Recovery Method
- How Do You Calculate Cost Recovery?
- What is meant by Cost Recovery?
- Advantages and Disadvantages of Cost Recovery Method
- Cost Recovery Example
What is the Cost Recovery Method?
Cost recovery method is a revenue recognition method in accounting in which a business recognizes an income from a sale transaction only when the cost element of the sale has been collected from the customer in cash.
As soon as the payment recovers the cost of the product, the seller records the remaining cash receipts (if any) as the income.
Essentially, using this technique of revenue recognition raises the question of why would a seller even have any kind of business with such a purchaser who poses uncertainty regarding the payment.
What is meant by Revenue Recognition?
Revenue recognition is one of the key processes in accrual accounting and is a generally accepted accounting principle that identifies when income is converted into revenue.
In revenue recognition, revenue is recorded when it has been earned and when it can be guaranteed to be paid. One of the types of revenue recognition is cost recovery.
When to Use the Cost Recovery Method
Cost recovery method would be applicable to any of the situations given in the following:
- The cost recovery method is utilized when there is an improbability of receiving the cost of the sales.
- It applies to companies that sell their goods on credits to the customers.
- It is also used when the owner is unable to justify an installment method.
- The cost recovery method is also applicable in scenarios where the seller is not able to arbitrate the sale value accurately.
How Do You Calculate Cost Recovery?
The calculation of the Cost Recovery is done by following the given steps:
Cost recovery is calculated by the following formula:
Cost Recovery = Total Revenue - Cost of the Product
Estimate the Cost of Your Projects
The first step is to assess the total incurred cost for completing a project. Enlist all the equipment, hardware, software, any other expenses which will add up to your project cost.
Monitor the Revenue Continuously
Once you have completed and delivered the project, keep a track of the payments made by your client. The payments could be either in installments spread out over a long period of time or a lump sum. In both the cases, carefully make notes of the income and also the amount that is still to be paid (or the unrecovered costs).
Quantify your Profits
Finally, subtract the cost of your project from the total revenue to quantify the profits.
What Is Meant by Cost Recovery?
Recovering a business expenditure, or recovering the cost of a business-related expenditure, forms the basis of cost recovery.
Accountants use cost recovery accounting to recover a business expense through depreciation, which they generally do through the use of the accelerated cost recovery method. The depreciation tax law allows an accountant to lower taxes a business pays, resulting in higher profits.
Advantages and Disadvantages of Cost Recovery Method
The advantages and disadvantages of cost recovery method are as described in the following table:
Advantages | Disadvantages |
Cost recovery is a dependable method in cases that have lesser guarantee of recovery of the money from the client. | Using the cost recovery method, there is a delay in recognizing the gross profit. |
The tax payable is only after the entire recovery of the cost of the product. Consequently, the owner can make savings and utilize this money in other business operations. | The period in which the sale was made and the period when the actual profit was recorded for that sale may differ. |
Cost Recovery Example
Let’s assume that a company sells its goods on credit to its customers. Therefore, the company follows the cost recovery method to estimate its revenue. Here are the particulars of the sales and transactions of the company:
Sale made to Mr. X on October 1, 2017 = $350,000
The cost of the goods sold = $300,000
Amount received upfront for the sale = $50,000
Rest of the payment in installments was made as:
Amount received in 2018 = $50,000
Amount received in 2019 = $100,000
Amount received in 2020 = $50,000
Question: When will the company recognize the profits in accordance with the cost recovery method?
Solution:
Based on the cost recovery model and the payments received so far by the company, the present scenario looks like this:
- Now, $50,000 is the profit for the company which comes from (Sale-Cost): ($350,000 - $300,000)
- This profit cannot be recognized in the duration when the sale was made. In contrast, it will be identified when it gets the payment after recovering the cost of the sold goods
- Total payment received the subsequent years 2018, 2019, and 2020= ($50,000 + $100,000 + $50,000). This is the cost of the goods sold. Therefore, the company does not record any earnings
- Eventually, the amount received in 2020 ($50,000) will be recorded as income
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Key Takeaways
Before we close, let’s run through the important points from the post:
- Cost recovery method is a revenue recognition method in accounting in which a business recognizes an income from a sale transaction only when the cost element of the sale has been collected from the customer in cash.
- Revenue recognition is one of the key processes in accrual accounting and is a generally accepted accounting principle that identifies when income is converted into revenue.
- Cost recovery method would be applicable when there is an improbability of receiving the cost of the sales or when the owner is unable to justify an installment method or where the seller is not able to arbitrate the sale value accurately.
- Recovering a business expenditure, or recovering the cost of a business-related expenditure, forms the basis of cost recovery.