What is the Cost Recovery Method?

Examples of Cost Recovery Method

Example #1

For revenue recognition, the company follows the cost recovery method as there is uncertainty concerning the recovery rate of the money from many of the business’s customers. For example, Company A ltd. sells the goods on credit to its customers. On September 1, 2016, it sold some goods on credit to one of its customers, Mr. Y, for $ 250,000. The cost of the goods sold for company A ltd was $ 200,000.

When to recognize the company’s profits as per the cost recovery method? At the time of sale, the company received $ 50,000 instantly, and the company received the rest of the payments in the subsequent years. $ 50,000 were received in the year 2017, $ 100,000 in the year 2018, and the balance of $ 50,000 was received in the year 2019.

According to the cost recovery method, the company will not record the gross profitRecord The Gross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more or the income generated against the goods that are sold to the customer until the total cost element related to the respective sale has been received fully by the company from the customer. After the whole cost amount has been received, the remaining amount will be recorded as an income.

  • In the present case, the company sold some goods on credit to Mr. Y on September 1, 2016, for $ 250,000. The actual cost of the goods sold was $ 200,000.The company received the payment against the goods sold in installments. $ 50,000 were received instantly, $ 50,000 were received in 2017, $ 100,000 in 2018, and the balance of $ 50,000 in 2019.Now, $ 50,000 ($ 250,000 – $ 200,000) is the profit of the company, which it will not recognize in the accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company’s overall performance.read more in which the sales are made; rather, the same will be recognized as income in the period in which payment is received after recovering the cost of goods sold.The Sum of the amount received in 2016, 2017 and 2018 is $ 200,000 ($ 50,000 + $ 50,000 + $ 100,000) which is equivalent to the cost cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.
  • read more, so, no earnings will be recorded in those years.However, the amount received above the cost of goods sold in 2019, amounting to $ 50,000, will be recorded as the earnings of 2019.

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Example #2

On October 1, 2013, the Sapphire Corporation, a steelmaker, sold some steel bars for $80,000. The customers are required to satisfy four yearly payments of $20,000 and interest payments every October 1, starting November 1, 2013, as per the agreement. The steel bar formation cost is $56,000. The firm’s fiscal yearFiscal YearFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more concludes on December 31.

The company has begun to recognize profits after two straight years of operations starting October 1, 2015, and after successful cost recovery.

Advantages

  • The company uses the cost recovery approach for revenue recognition in case there is reasonable uncertainty concerning the collection of money from the customers against the sales made on the credit basis because, by far, this method is the most conservative out of all of the revenue recognition methods available.With the cost recovery method, there is a delay in the due date of the tax payment as the tax will be payable only after the company has recovered the full cost of the product. So, with this method, the owner of the business can make some savings.

Disadvantages

  • Using the cost recovery method, although the company recognizes the cost and sales, the gross profit in respect of the same will not be recognized even if some sale is essentially the receivable for the company, and the gross profit will be recognized only in case the entire receipts have been received.In this method, the company’s profits are referred to as the period when the payment against that profit is received. So even if the sale pertains to one period, the company would not be able to show it as income for that period.

When to use the Cost Recovery Method?

Conclusion

Thus, in the case of the cost recovery method, the company will recognize the amount earned over and above the cost as gross profit or income when the same has been received after recovering all the costs incurred by the company, i.e., the company will recognize the revenue only when the actual money has been received by it from the customers against the sales made.

The company uses the cost recovery approach for revenue recognition in case there is reasonable uncertainty concerning the collection of money from the customers against the sales made on the credit basis because, by far, this method is the most conservative out of all of the revenue recognition methods available.

This article has been a guide to the Cost Recovery Method. Here we discuss an example of a cost recovery method with a detailed explanation of the advantages, disadvantages, and limitations. You can learn more from the following accounting articles –

  • Incremental RevenueFormula of Cost of SalesRecord Unearned Revenue Journal EntriesMeaning of Accrued Revenue