Percentage-of-Completion Method Explained

The percentage-of-completion method allows contractors, consultants, and other project-based businesses to recognize revenue incrementally as work progresses on a long-term contract, rather than waiting until the project is finished. Under ASC 606, this is the standard approach for most performance obligations satisfied over time.

How It Works: The Core Mechanics

Under the percentage-of-completion method, you estimate what fraction of a contract is complete in each reporting period and recognize that fraction of the total contract revenue and costs.

Formula:

Revenue Recognized in Period = (% Complete) × (Total Contract Price)

If a $10 million construction contract is 40% complete, you recognize $4 million in revenue. Simultaneously, you record the costs incurred to reach that 40% point. The difference is the profit or loss on the contract so far.

Example:

A contractor signs a three-year highway project worth $15 million with estimated total costs of $12 million (gross margin: $3 million, or 20%).

• Year 1: Costs incurred: $3.6 million. Estimated total cost: $12 million. Completion: $3.6M ÷ $12M = 30%.

  • Revenue recognized: 30% × $15M = $4.5M
  • Gross profit: $4.5M − $3.6M = $0.9M

• Year 2: Costs incurred this year: $4.8 million. Cumulative costs: $3.6M + $4.8M = $8.4M. Completion: $8.4M ÷ $12M = 70%.

  • Cumulative revenue to recognize: 70% × $15M = $10.5M
  • Revenue recognized this year: $10.5M − $4.5M = $6.0M
  • Costs incurred this year: $4.8M
  • Gross profit this year: $6.0M − $4.8M = $1.2M

• Year 3: Final costs: $3.6 million. Cumulative: $12M. Completion: 100%.

  • Cumulative revenue to recognize: 100% × $15M = $15M
  • Revenue recognized this year: $15M − $10.5M = $4.5M
  • Costs incurred this year: $3.6M
  • Gross profit this year: $4.5M − $3.6M = $0.9M

The $3 million total margin is spread across all three years in proportion to work completed. This matches revenue and profit to the period in which the work was actually performed—the hallmark of the matching principle under accrual accounting.

Measuring Percentage Complete: Input vs. Output Methods

The percentage-of-completion method requires an estimate, and the challenge is deciding how to measure “complete.” There are two broad approaches:

Input Method (Cost-to-Cost):
Divide actual costs incurred to date by the total estimated costs for the full contract. This is the most common approach for construction and large manufacturing projects because costs are measurable and controllable.

• Pro: Objective, relatively easy to audit, aligns with actual resource consumption.
• Con: Assumes costs are proportional to work performed (not always true; early phases may be cheaper per unit of progress).

Output Method:
Measure completion based on physical units delivered, milestones reached, or time elapsed—whatever best reflects the pattern of performance.

• Pro: More directly reflects the customer’s perspective (“is the product getting closer to what I paid for?”).
• Con: Often requires custom metrics per contract; harder to standardize and audit.

For a software development contract, you might measure completion by counting modules delivered. For a consulting engagement with deliverables at specific dates, milestones work well. For a construction project, input (costs) is standard.

The Estimate Trap

Percentage-of-completion accounting rests on a critical assumption: you can reasonably estimate the total contract cost and whether the contract is profitable. If estimates are wildly inaccurate, your year-by-year profit recognition is wrong.

When estimates change mid-contract, you adjust the revenue and profit recognized in the current and future periods, not past periods. This is a “change in estimate” under GAAP, treated prospectively.

Example of an estimate revision:

In Year 2 of the highway project, the contractor discovers that the remaining work will cost $4.2 million instead of the originally forecast $3.6 million. Total cost is now $3.6M + $4.8M + $4.2M = $12.6M, not $12M.

• New completion percentage (Year 2 end): $8.4M ÷ $12.6M = 66.67%
• Cumulative revenue to recognize: 66.67% × $15M = $10M
• Revenue to recognize this year (revised): $10M − $4.5M = $5.5M
• Profit this year (revised): $5.5M − $4.8M = $0.7M

The Year 2 profit is lower because of the estimate revision, and the total expected profit falls from $3M to $2.4M. This revision flows through the income statement in Year 2; you don’t restate Year 1.

Percentage-of-Completion vs. Completed-Contract

The main alternative is the completed-contract method, where revenue and profit are recognized only when the contract is finished. This was more common before ASC 606 but is now rarely used under current revenue recognition standards.

Under completed-contract, if your three-year project finishes in Year 3, all $3 million in profit appears in Year 3, with zero profit in Years 1 and 2. This distorts financial reporting and is why ASC 606 made percentage-of-completion the default for most contracts.

Contract Assets and Liabilities

As you recognize revenue under percentage-of-completion, you may record a contract asset or a contract liability on the balance sheet.

• Contract asset (accrued revenue): You’ve recognized more revenue than the customer has paid. You have a right to payment.
• Contract liability (deferred revenue): The customer has paid more than the revenue you’ve recognized. You owe performance.

In the highway example, if the customer pays $4 million in Year 1 but you recognize $4.5 million in revenue, you have a $0.5 million contract asset (unbilled receivable). If the customer pays $5 million, you have a $0.5 million contract liability (deferred revenue).

These accounts highlight the timing gap between recognizing revenue and receiving cash—a key insight for cash flow analysis.

When the Estimate Becomes Uncertain

If you cannot reasonably estimate the total cost or the likelihood of profit, ASC 606 allows you to recognize revenue only to the extent of costs incurred—a conservative approach that avoids creating profit on a contract you cannot predict. Once you can estimate outcomes reliably, you switch to full percentage-of-completion.

Real-World Application: Construction and Software

Large construction firms, engineering companies, and custom software developers use percentage-of-completion as their primary revenue model. Homebuilders use it per phase or per house. Consulting firms use it for long-term engagements. Defense contractors use it for multi-year weapons programs.

The method’s credibility depends on the maturity and control of the business’s cost estimating and project management. A contractor with poor historical cost data and sloppy change-order tracking will have unreliable percentage-of-completion calculations. A contractor with strong cost controls and a history of accurate estimates can defensibly use the method and provide reliable financial statements.

See also