Question

When we formed the construction contract, do we need the margin percentage for the percentage-of-completion method? I am trying to calculate the revenue. I have information about the estimated cost, cost incurred per year, the finalized cost, project years, and margin. However, I am not sure it is necessary. It said that the worker wants to add a margin of % on its cost estimate.
Can anyone help me to use an example to explain to me?

Answer 1

If workers wants to add margin of certain % on its cost estimate then Total contract price will be according to cost estimate.We can say that the contract amount is a margin over estimated cost of the contract.

Lets say if Total estimated contract cost of the project by the contractor is 8 million and margin percentage is 25%. Total contract price agreed between parties will be 8 million + 25% on 8 million=  10 million. Then we can say that 10 million will be our revenue by incurring cost of 8 million. If cost actually incurred does not change then the extra 2 million which contractor is getting is his margin/profit.

When actual Cost incurred is more than the estimated cost:

Lets take the same example total estimated contract cost of the project by the contractor is 8 million and Margin is 25% then total contract price agreed between parties is 10 million . But say contractor actually incurred cost of 9 million. Then if he will recognise revenue according to his actual cost. It will become 25% on 8 million+ 25% on extra 1 million= 2+0.25= 2.25 million.

But contract price agreed between parties is 25% of cost estimate and not on actual cost so it cannot exceed above 10 million because of extra cost incurred. So, we have to decrease this extra revenue.

Lets see the calculations

Percentage completion in last year will be=(cost incurred to date /estimated total cost )*100= (9 million/8 million)*100= 112.5%

Generally we calculate revenue recognised by %completed * contract price- revenue previously recognised.

(we are ignoring revenue previously recognise for now.)

Then revenue will be= (9 million/8 million)* 10 million= 1.125= 11.25 million.

But revenue cannot be recognised more than 10 million so we will have to decrease this calculated revenue by 1.25 million. and also completion to date by 11.2% to make it 100%.

You have to see if total revenue is more than agreed amount and adjust it accordingly. This adjustment generally occurs in last year after completion of contract when 100% cumulative revenue is recognised.

Gross profit is total revenue recognised-total cost incurred =10-9 = 1 million