If you are in the construction industry or read our prior article on Methods of Accounting for Construction Contractors, chances are you have heard of the percentage of completion (PCM) method of accounting. In this piece we will cover what the PCM is, how it works and why it matters.

What is the Percentage of Completion Method?

The PCM method is the best way to accurately track and measure the revenue earned on a long-term contract. This allows you to recognize revenue in the appropriate period and monitor the profitability of your contracts in progress. Typically, a long-term contract is one that spans more than one reporting period (or year). In order to properly use the PCM, you must be able to accurately estimate a contract’s total cost at inception of the contract, and you also must be able to accurately track costs to date as the contract progresses.

How does the Percentage of Completion Method work?

A work in progress (WIP) schedule is commonly used in the PCM to calculate and track the revenue earned on jobs in progress. To properly complete a WIP schedule there are four main pieces of information that you will need:

1. Contract Price – The total agreed-upon contract price, including any change orders.
2. Total Estimated Cost of Construction – The total expected direct and indirect cost upon completion, including change orders.
3. Costs of Construction to Date – The total actual direct and indirect costs incurred to date as of the end of the reporting period.
4. Progress Billings – The total amount billed to the customer as of the end of the reporting period.

These four inputs drive the WIP schedule and are used to calculate the three primary outputs that help you assess your current jobs and your firms’ financial performance.

1. Percent Complete = Cost of Construction to Date / Total Estimated Cost of Construction

• This measures how far along the project is in its life using the cost-to-cost input method.
  • The cost-to-cost input method assumes that construction costs are the primary driver of the contract and therefore are the most accurate way to measure progress towards completion. As costs are incurred a proportionate amount of revenue is considered earned and can be recorded.

2. Revenue Earned to Date = Percent Complete x Total Contract Price

• This measures the amount of total revenue you should recognize on a specific job for the reporting period.

3. Overbilling or Underbilling = Revenue Earned to Date – Progress Billings

• This compares how much you have billed to how much you have earned on each job.
  • A positive value represents an underbilling. This means you have earned more revenue than you have billed. An underbilling is recorded on the balance sheet as an asset as you have yet to bill for the revenue you earned.
  • A negative value represents an overbilling. This means you have billed more than the revenue you have eared. An overbilling is recorded on the balance sheet as a liability as you have billed in advance for work (costs) you have yet to perform(incur).

Why does it matter?

Without the PCM, the revenue recognized during the reporting period would simply equal the total you billed for the period. Ultimately, this would not accurately reflect the amount of work performed, and this would cause large, improper swings in profitability from period to period.  The PCM corrects this by recording the overbillings(liability) and underbillings (asset) on the balance sheet. The net of the overbillings and underbillings adjusts revenue to the proper amount earned for the period.

The financial statement revenue recognition rules under Generally Accepted Accounting Principles (GAAP) changed starting in 2019 with the issuance of Accounting Standards Update (ASU) 2014-09 topic 606 . While GAAP requires that the new standard be followed, most small contractors have found that the PCM method is substantially similar when it recognizes revenue under a cost-to-cost input method as a long term contract’s performance obligation is satisfied.

Further, while the GAAP rules have changed, federal tax law (IRC Sec. 460) still generally requires construction contractors to account for long-term contracts using the PCM as the default method, unless an exempt method for taxes is available for use.

Ultimately, the PCM is a valuable tool for construction contractors because it provides accurate data regarding each contract’s performance and profitability.  A WIP schedule should be generated monthly to help you properly monitor your jobs and provide the most accurate financial data for your internal financial statements. Please reach out to a member of our team if you have questions regarding the use of the PCM, a WIP schedule, or how they may apply to your business. Interested in more topics tailored to the construction industry? Read our our article on Sales and Use Tax Basics for Contractors and subscribe to our email list for timely updates and informative articles.