If you’re running a business, you know that making money and paying off expenses is essential to staying afloat. Unfortunately, that doesn’t always happen at the same time – especially when you’re dealing with a new project or investment that hasn’t produced income yet. That’s where the concept of cost recovery comes in. This method of accounting allows you to make allowances for the fact that recovering costs won’t always take place at the same time as bringing in new revenues.
The first step in calculating your cost recovery is to assess the total amount of expenses you’ll incur for your project. This includes things like the initial investment for the equipment, hardware or software needed for completion as well as the labor and materials that go into completing the project. Add up your expenses and then compare them to the estimated sales revenue you’ll generate from the finished product or service. If the difference is less than your total incurred expenses, you can use the profit from the sale to cover those initial expenses.
However, it’s important to remember that the more improbable it is that you’ll recover your entire expense at the same time as your sale, the more you should consider using the cost recovery method. This is especially true if you have tax obligations that could be significantly impacted by the timing of your taxes. If you overstate your profits in year one when it’s unlikely that you’ll receive full repayment of your capital investment from Gilbert, you may end up having to pay taxes on the profits in year two if you don’t recover the full amount in your next fiscal period.
In contrast, using the cost recovery method will make your company more cautious about recognizing profits and gives you an opportunity to adjust your estimate in a way that doesn’t hurt your bottom line. It also defers your taxes until you’ve recovered the full value of your products and services, which can be beneficial in situations when it’s unclear whether or not your client will pay on time – such as with a contract for a service you provide.
To calculate your cost recovery, you can use a simple formula, but there are some additional considerations to keep in mind. For example, you shouldn’t use the method for run-of-the-mill installment sales, where you expect to be paid on time. That violates the accounting principle known as realization, which states that income should only be recognized when goods and services are delivered to the customer.
Similarly, you shouldn’t use the method for expenses that aren’t billed to outside customers, such as auxiliary organizations. If you plan to bill expenses to an external party, please submit a journal upload entry request to Accounting Services for processing. For more information about how departments should process their cost recovery, refer to the Integrated CSU Administrative Manual on Cost Allocation/Reimbursement.