Cost recovery is a method of bookkeeping used in situations where it’s improbable that you will receive the full value of your goods or services. For example, if you sell equipment to someone on credit and you’re unsure whether they will make incremental payments on time or not at all, the cost recovery method allows you to recognize revenue and cost of goods sold but defer gross profit until cash is received.
This way you can be certain that your accounts receivable are accurate and that you will be able to pay taxes on the true profit when it is realized. It’s also a more conservative approach to profit recognition since it only counts your earnings once your outstanding costs are fully recovered, rather than when cash is received.
The purpose of the cost recovery system is to recover direct and indirect costs related to the operation of programs funded from a variety of sources. These may include auxiliary organizations, internal funds (e.g., research grants) and external parties.
To determine the appropriate rate for charging your customer, you must first calculate your total project cost. This includes any capital and operating expenses needed to complete the project, as well as any other associated administrative expenses such as utilities, insurance or a service manager fee. Once you know your total project cost, you can determine what rates are needed to cover these costs and to generate a profit.
You can decide whether to use a single rate to cover both owning and operating costs or two separate rates, one designed to recover owning costs and the other to recover operating costs. For example, you might choose to charge your customers a flat percentage rate of the total project cost or you might decide to set different rates for various types of equipment, based on whether it’s being used for a service or as an asset.
For each rate you design, you will need to determine which expenses are eligible to be included in the rate, as well as how much you are willing to accept for a profit. Remember that you will need to record any charges and receipts in your accounting records in the fiscal year in which the expense is incurred or the services are rendered.
In general, you should review your cost recovery policy at least biennially. This is the best way to ensure that you’re generating an acceptable profit and that any exceptions to your policy are still valid. You can also use this time to review and update your internal financial procedures and controls, so that you’re sure everything is up to date. In addition, you should be aware that your cost recovery policies can affect the amount of taxes you’ll owe, so be sure to take this into consideration when planning your budgets.