The percentage-of-completion method is the standard practice of accounting used for businesses or individuals who enter into contracts that span several years. This method is most often associated with construction projects to accurately determine the costs and profits within one year of a multi-year contract. It is called the percentage-of-completion method because it measures the part of the project already completed in terms of the estimated costs of the entire project and the amount of the contract itself. Performing this method requires dividing the costs used in a single year by the estimated total costs and then multiplying that number by the total estimated gross profit.
It's not uncommon for construction projects to run over a course of several years, with each year presenting different costs to the company undertaking the project. For instance, the prices of material used in the construction can change from year to year, or weather complications may cause a delay in the project. These possibilities require an accounting process that takes these variables into consideration. The percentage-of-completion method provides for these variables and narrows down the accounting of costs and profits to the period being reported.
Imagine, for example, that Company A has entered into a contract that pays them $10,000 US Dollars (USD) to complete a construction project, while the estimated cost of completion for the project stands at $8,000 USD. This means that the company's expected total estimated gross profit for the project is $2,000 USD, or $10,000 USD minus $8,000 USD. In a single year of this project, a company amasses costs of $4,000 USD.
To reach the percentage-of-completion costs incurred, the $4,000 USD is divided by the $8,000 USD total cost estimate, which comes to 0.50. This means that the company has incurred 50 percent of the total estimated costs of the entire project in this single year. The 0.50 is then multiplied by the total estimated gross profit to determine the company's profits for the year. In this example, 0.50 is multiplied by $2,000 USD, meaning that the company's gross profit for the year in question is $1,000 USD.
When using the percentage-of-completion method, a company must construct its accounting journal to accurately reflect the data being used. Construction in Process (CIP) should be the part of the ledger that reflects the costs incurred up to the current point. There should also be a contra account reflecting the amount of billing the company has already issued to their clients. In this way, the journal will show the gross profits, expenses, and revenues for each year of the contract.