Percentage-of-Completion Method

On a three-year construction project, recognizing all revenue and profit in year three is misleading to investors watching interim results. The percentage-of-completion method recognizes a proportional slice of profit each year as the contractor advances, smoothing reported earnings and reflecting economic reality.

Revenue follows work, not cash

The percentage-of-completion method hinges on a simple premise: if a contractor is 60% done with a project, it has earned 60% of the contract profit. Revenue, costs, and gross margin are recorded in income statements in proportion to work completed.

This contrasts with completed-contract method, which defers all recognition until the job is finished. Percentage-of-completion is more aligned with accrual accounting principles and is preferred under GAAP for contracts where reasonably reliable estimates of progress and profitability exist.

How it works in practice

Consider a contractor with a $10 million, two-year contract to build a warehouse. Estimated costs are $8 million.

Year 1: The contractor incurs $4.2 million in costs and determines through inspections and engineering that 50% of the work is complete.

• Revenue recognised: $10M × 50% = $5M
• Costs recognised: $4.2M (actual)
• Gross profit: $5M − $4.2M = $800K

Year 2: The contractor incurs $3.8 million in costs (completing the project).

• Revenue recognised: $10M × 100% = $10M total; so $10M − $5M = $5M in year 2
• Costs recognised: $3.8M (actual year-2 costs)
• Gross profit in year 2: $5M − $3.8M = $1.2M

Total profit reported across both years is $2M ($800K + $1.2M), which equals the contract price ($10M) minus total costs ($8M). The method captures the full profit but spreads it based on work done.

Measuring progress

The critical variable is determining what percentage is complete. Methods include:

Cost-to-cost: Compare actual costs incurred to total estimated costs. If $4M of an estimated $8M has been spent, the job is 50% done. This is the most common method because costs are easily documented.

Labour-hours: For labour-heavy projects, divide actual labour hours to date by total estimated labour hours.

Units delivered: If the contract specifies delivery of discrete units (e.g., 100 manufactured components in a supply contract), completion percentage is units delivered ÷ total units.

Surveys and inspections: Engineers or architects certify what fraction of work is complete—useful for construction where physical progress is observable.

Milestones: If the contract defines stages (foundation complete, framing complete, finishing), achievement of each milestone triggers recognition of a fixed revenue percentage.

Each method has merits and pitfalls. Cost-to-cost is objective but can be gamed (front-loading labour into early months). Inspections are honest but subjective and slower. Many contracts use hybrid approaches.

Why it matters for financial reporting

Investors evaluating a contractor want to see earnings that reflect economic performance, not cash timing. Under percentage-of-completion:

• Income smoothing: Profit is spread across contract duration, reducing wild swings if all profit were deferred until the final year.
• Transparent progress: Interim financial statements show whether a project is profitable as it progresses, not after the fact.
• Faster earnings: A contractor does not wait until year three to report year one’s profits, improving reported return on assets and shareholder returns.
• Matching principle: Revenue and direct costs are matched in the same period, adhering to accrual-accounting logic.

This makes percentage-of-completion the standard for contractors, civil engineers, and defence contractors working on multi-year programmes.

Risks and adjustments

The method’s accuracy depends on the reliability of cost estimates. If estimates prove wildly wrong, the contractor must adjust.

Estimate changes: If a contractor initially estimated $8M but halfway through realises the true cost is $9M, the percentage-of-completion calculation must be revised. Past-year figures are usually left unchanged, but current and future periods restate based on the new estimate. This can create surprisingly large earnings swings in a single quarter.

Loss contracts: If at any point the contractor realises the contract will be unprofitable, the entire expected loss must be recognized immediately—a reversal of the progressive approach. If a $10M contract with estimated $8M cost is halfway done but new estimates say total costs will be $12M, the contractor records a $2M loss in the current period.

Change orders: Contracts often include customer-requested changes. Revenue must be established for the change before it is recognised, avoiding disputes over add-ons.

Percentage-of-completion versus completed-contract

The two methods reflect different philosophies about when revenue is “earned”:

Completed-contract method is sometimes preferred when progress cannot be reliably measured or when high contract uncertainty makes current estimates unreliable. It is safer but less transparent.

Regulatory preference

Under GAAP, percentage-of-completion is the default for long-term contracts when progress can be reasonably estimated. IFRS, the global standard, uses the term “over time” recognition with similar logic. Both bodies prefer it because it better reflects when control of a good or service passes to the customer.

For government contractors and defence projects—where multi-year contracts are standard—percentage-of-completion is mandatory in audited statements.

See also