Revenue Recognition in Managing Projects

One of the issues that the founders of Setpoint, Joe Cornwell and Joe VanDenBerghe realized early on was that they did not like the way the accountants did project based accounting. At the crux of the problem was the cost versus budget approach to revenue recognition. Under GAAP (Generally Accepted Accounting Principles) the rule for project revenue recognition was percent of cost complete. For example, if one spent $1,000,000 on a project and the total project cost budget/estimate to complete was $5,000,000 then the project would be considered 20% complete for revenue recognition purposes. So to complete this example if the project revenue was $7,000,000 then 20% of revenue would be $1,400,000. So the period profit and loss statement for that project would look as follows:

Revenue    $1,400,000
Expenses   $1,000,000
Profit         $  400,000

The Joes questioned the validity of that profit. They debated with their accountant. They struggled with the concept. Their issue was with the way their automation equipment business operated. A large machine can take 6-9 months to complete. A lot of the work is at the end of the project when the machine is starting up and being debugged. The problem with the GAAP accounting method is that the profit is recognized before the real tough work is completed. As an example say Setpoint builds a $3,000,000 machine that will take about 9 months to complete. In the first 3 months the machine’s materials are received and design is complete. Let’s say that material costs on the machine are $1,500,000 and the design cost another $100,000 in labor. So by the GAAP accounting method the machine is $1,600,000/$3,000,000 or 53% complete. Therefore, 53% of the projected profit can be recognized in the first 3 months. One the other hand, a small fraction of the total labor to complete the job has been incurred at that point.

Let’s assume that Setpoint estimates that the total labor costs will be $1,000,000. So by labor measures Setpoint has spent 10% of its labor budget or $100,000/$1,000,000. Yet the accountant will say that the machine is 53% complete. This discrepancy can create a false sense of safety early on in a project when little work is done. Furthermore, if there was large labor overruns later in the project during the startup/debug process those past profits could be overstated.

Because of this issue Setpoint decided to measure revenue in a different way. At Setpoint, we measure percent complete by labor only. We evaluate how much labor was spent on a project every week and then we estimate labor required to complete the work and use labor only to recognize percent complete for revenue recognition.

Setpoint uses two methods for estimating labor. First, for smaller projects we look at labor by discipline and estimate how much will be needed to complete the project relative to what has been spent. For our larger projects we look at these numbers based on schedule based earned value tools. We update these projects on a weekly basis so our project engineers can stay close to the performance of our projects and to make it possible to communicate our profitability to the entire company on a weekly basis. We will talk more on project tracking and earned value in a later blog.

We also have a white paper that talks more about our project management techniques, feel free to download it.