The cost recovery method is a way of recognizing and classifying revenue in accounting. When using the cost recovery method, a business doesn’t record income related to the sale of its services until the money collected from a client exceeds the cost of the services rendered. You might also hear the cost recovery method referred to as the collection method.
As a freelancer using the cost recovery method, you wouldn’t record your profits until the payment you receive from a client covered all your expenses related to the project.
What Is Revenue Recognition?
Revenue recognition is a generally accepted accounting principle that identifies points at which income becomes actual revenue. Revenue recognition is a key process in accrual accounting.
Using the principle of revenue recognition, revenue is recognized and recorded when it is actually earned and when there’s an assurance of payment. Cost recovery method is one type of revenue recognition. You can get a full rundown of revenue recognition methods here.
When to Use the Cost Recovery Method
The cost recovery method can give an accurate view of the financial state of your business at any given time, as it doesn’t predict future revenue. Because of this, the cost recovery method is considered to be the most conservative form of revenue recognition in business accounting.
If you’re not sure that you’ll ever receive the full income for which you’ve invoiced a client, or if you don’t know that you’ll receive all payments in a single calendar year, it’s a good idea to use the cost recovery method of accounting so you don’t overestimate the revenue you’re likely to receive. In any instance of uncertainty around revenue, the cost recovery method is recommended.
How Do You Calculate Cost Recovery?
The following steps will have you calculate cost recovery for your business revenues:
1. Calculate Your Project Costs
To calculate cost recovery, you first need to determine the costs you’re incurring to complete a project. Do you have costs for subcontractors, equipment or software? Add all these up to calculate your total project costs.
2. Track the Flow of Revenue
Whether your client sends you a lump sum payment after you’ve completed a project, or pays in multiple installments over a longer period of time, you’ll want to track all the revenue flowing in to your company, along with your unrecovered costs.
3. Determine Your Profits
Calculate the profits you make on the project using the cost recovery method, by subtracting your project costs from your total revenue. All of your revenue and costs should be recorded as business transactions.
Cost Recovery Method Example
Let’s say you’re a freelance web developer working on a project for a new client and you’ve hired a freelance copywriter to produce all the content for your client’s website. You’ve heard feedback from other developers that this particular client has sometimes failed to pay their invoices, or failed to do so in a timely manner, so you’re using the cost recovery method to record your revenue.
Assuming that hiring a copywriter is the only cost you’ve incurred for the project, under the cost recovery method, you would only recognize and record the revenue earned from this project when your income exceeds the cost of employing the copywriter.
You’re billing the client $20,000 for the project. You pay the copywriter you hired a flat fee of $10,000 for their work, beginning September 1.
The client will pay the cost of your services in installments, with an initial deposit of $5,000 paid on September 1 and the outstanding balance to be paid in two installments of $7,500 on October 1 and November 1.
Using the cost recovery method, you would recognize the client’s payments in the following way:
| Date | Cash (debit) | Installment Accounts Receivable (credit) | Unrecovered Cost | Realized Gross Profit |
| September 1 | $20,000.00 | $10,000.00 | ||
| September 1 | $5,000.00 | $5,000.00 | $5,000.00 | |
| October 1 | $7,500.00 | $7,500.00 | 0 | $2,500.00 |
| November 1 | $7,500.00 | $7,500.00 | 0 | $10,000.00 |
| $20,000.00 | $20,000.00 | $10,000.00 |
What Is Meant by Cost Recovery?
Cost recovery is the principle of recovering a business expenditure, and generally refers to regaining the cost of any business-related expense.
For accountants, cost recovery accounting is a tax concept that refers to the recovery of an expense, and accountants generally do this through depreciation. Using depreciation tax law, an accountant can lower the taxes a business pays which then increases the profits the company earns.