How Much Do You Really Know About Cost Recovery Method ?
Application of Cost Recovery Method
The cost recovery approach is way of recovering an expenditure which a business takes on. Under the recovery method, the revenue is recognized only to the extent of receipts from buyers. Thus, the initial payments that customers make are taken in the form of cost recovery of goods sold. The remaining amount that is collected is treated as gross profit.
The cost recovery formula is used when the recoverability of revenue is not sure, or the sale value can’t be determined. In general terms, the cost recovery method is a method of recovering the cost of any given expense.
Cost Recovery Method – Explanation
Under the cost recovery numbers, nothing is considered income until the cost of the product or service sold is recovered entirely in the form of cash. The cost recovery method is used when the selling price of a product is highly uncertain. This method of cost recovery is considered relatively conventional when compared to other forms of recognizing the revenue.
As per the cost recovery formula, the instalments after selling a product should be segregated between principal and interest. Under the instalment method, the amount paid as initial instalments is used to recover the entire sales costs while remaining considered the gross profit of the company. Once the total sales value is recovered, the remaining cash receipt is regarded as gross profit.
Cost Recovery Method – Example
ABC Inc. is engaged in the manufacturing and selling of specialized manufacturing equipment. The company has an excess capacity of 30% as of 1 January. The company sold equipment worth $20 million to XYZ Inc., a company facing a liquidity crunch. The machine cost $10 million in manufacturing. The receipts from XYZ in the financial year 2019 are as follows:
- First Quarter – $3 million
- Second Quarter – $6 million
- Third Quarter – $4 million
- Fourth Quarter – $7 million
Now, let’s determine the gross profit in each Quarter under the cost recovery method.
Under the cost recovery method, revenue or income is recognized only to the extent of receipts. So in Q1, the revenue recognized is $3 million, which matched a cost of $3 million, resulting in zero gross profit.
In Q2, the revenue recognized is $6 million, which matched with a $6 million cost, resulting in zero gross profit.
In Q3, revenue recognized is $4 million, which matched the remaining cost of $1 million ($10 million – $3 million – $6 million), resulting in a gross profit of $3 million.
In Q4, no cost of the product was left, and the revenue recognized is $7 million, so gross profit is $7 million.
Usage of Cost Recovery Method
The cost recovery method helps business owners save some more money while paying taxes. This method is almost similar to the instalment system since both consider total revenue and total cost of goods sold. However, the instalment method considers part of the instalment cash collected as income, while the cost recovery method doesn’t find anything as profit until the money received exceeds the cost of production.