Supply Demand
Supply Demand Economies around the world are built through a direct relationship between sellers and buyers. The sellers are considered the suppliers of products and services, and
Cost recovery is an approach that requires the business to first specify the cost of goods sold abbreviated (COGS), which is the total cost of the inventory that has been purchased to be sold. COGS consists of both the direct and cost incurred or recurring.
Inventory creation has only one source of costs which is called direct cost. On the other hand, there are indirect costs which are considered to be the administrative and overhead costs related to the operational side of the business.
The cost recovery approach dictates that only the revenue is to be recognized when it covers the COGS.
This means the revenue of a company would not be recognized until cash is collected from the sales of a product or a service to which the revenue generated overcomes the initial investment in those products and services to be provided.
The idea here is if the company is already making losses from its initial investment through its sales then it’s not in the stage of cost recovery yet.
We could say that to follow the cost recovery approach, we would need to know our direct costs correlated to our products and services provided.
Then, we need to ensure that the amount of revenue generated by these products or services is high enough to cover their creation, and finally, we can recognize the revenue for the cost recovery process.
This approach is sound and healthy not only for the purposes of the cost recovery approach, but to also realize the overall performance of the company and to analyse the positioning of our products and services within the segments served.
So as an entrepreneur or a businessman this should be your ordinary approach to analyze your performance.
Identifying your direct and indirect costs would be the first step to be able to apply the cost recovery approach. Sales or sales transactions, will consist of direct costs from the materials used to create these sold products and any direct labor costs.
Indirect costs mean any indirect expenses that still exist for the creation of any product and service in the company, and those consist of expenses like overhead costs related to operating or the general operations of the business like rent, insurance, R&D, and any other admin costs.
Secondly, in order to apply this approach, is by measuring or calculating your profit margins from each transaction conducted.
It is calculated through the gross profit, which is the difference between your revenue minus the cost of goods sold. Once this figure is known then the profit to be earned is known from each transaction.
For instance, let’s assume you have an electronics shop and you offer a laptop for $500. The cost for this laptop was around $300, which consists of the materials utilized to develop and create the laptop and the direct labor related with making the laptop.
In this assumption or example, your gross profit margin is $200. After selling multiple laptops, your shop has made $2,000 in revenue.
Your cost of goods sold would be around $700, which consists of $300 for the materials utilized to make the laptops and $400 for the indirect costs associated with running the business.
If you then decide to apply the cost recovery method, it will not approve any profit until it earns $2,000 in revenue and has recovered $700 in COGS. If you offer or sell another laptop, the cost of goods sold will be $300, the same as the first laptop you have sold.
In terms of value, there are many advantages to this approach. Still, we keep this value to remind you it can only be grasped by those who run or own businesses that sit right with this approach as it provides high value for businesses with an aligned ecosystem to its intended segment to be served by this method.
Now, the limitations of this approach may vary, but based on your business nature you might find those limitations bearable or can be overlooked as this approach resonates better with your business and your customers behavior and purchase patterns.
Those limitations are:
When revenue is earned, a recognition should be undertaken, which is part of a process called revenue recognition. This process/recognition is crucial because the majority of the time, businesses usually incur expenses before they collect revenue from their customers.
The cost recovery approach or method is one approach to specify when this revenue can be and will be earned. The idea is that this method only recognizes the revenue after the initial capital for the provided products or services has been recovered.
This approach is suitable for businesses that deal in inventory-based transactions or businesses that manufacture these goods and services.
Hence, the revenue of these businesses will only recognize revenue once their COGS is recovered if they apply this approach.
To remind you how to calculate it, here is a recap:
The approach to cost recovery will require that, first you need to decide the costs you’re sustaining to finish your product creations. Are there costs related to your subcontractors, hardware or software? Sum up all these and calculate total direct costs related to your product.
If your clients inject you with a chunk of payment after you have completed a product creation, or if these clients paid in different installments over an extended period of time, it is crucial to track the return of this revenue back to your company along with unrecovered costs.
Measure the profits you will make off the products created once sold and use the cost recovery approach. This happens through subtracting your total cost of goods sold from your revenue. Once you do this you will be able to measure your profit.
Last example: for instance let’s say a company offers its products on credit to its potential customers. Hence, the company applies the cost recovery method to measure its revenue.
We could say that the particulars of the sales and transactions of the company.
Left over of the payment in installments is:
Now we could ask ourselves: When will the company acknowledge the profits in relevance to the cost recovery approach?
According to the cost recovery model and the payments made so far by the company, the present situation would be like this:
As we have mentioned this approach is suitable for a specific set of businesses that provide their products or services through a supply mode to retailers or through cash and credit. We could summarize the value or the key points of this approach as follow:
When you decide to apply a specific approach to make your business more efficient, you need to understand what changes you will need to make to apply this approach and the severity of these changes. You also need to realize the amount of value.
Value gained from any applied approach should be obvious for you as a businessman, employee or executive as the business can reach alerting stages because of simple decisions that seem too minor at times.
This approach has been applied by many companies that has the suitable environment for this approach to be applied, hence the value of this approach has been grasped by these products and service providers.
Before you apply the cost recovery method you need to know if the nature of your business aligns with the businesses that can use this approach, then understand your revenue, and finally the know-how.
If you think you will need more knowledge regarding this topic there are many courses in finance, administration, business analysis and many more topics related to the success of your business provided by Wall Street Oasis that you can definitely gain some major value from.
Researched and Authored by CEO of NeuralWize Ahmed Fagiry
Supply Demand Economies around the world are built through a direct relationship between sellers and buyers. The sellers are considered the suppliers of products and services, and
Market Exposure Investing is not just a hobby; it has become a sophisticated and facts-based activity. Today, investors can calculate the level of risk their investments are expose
Debt Settlement Individuals or organizations sometimes borrow money or capital to conduct cash-based activities that they previously didn’t have the financial resources needed to
Deal Fatigue Despite the ongoing boom in wealth management M&A activity, most individuals in these markets are taking part in a transaction for the first time. While certain ag
Credit Analysis Process Credit analysis is the process conducted by funders, bond managers, banks, and financial institutions that desire to calculate a corporation’s creditw
Cost Recovery Method Cost recovery is an approach that requires the business to first specify the cost of goods sold abbreviated (COGS), which is the total cost of the inventory th
Accounting Information System (AIS) What is an accounting information system? An accounting information system is a system that collects, stores, and processes financial and accoun
Activity Based Budgeting Budgeting for activities in organizations of any size can be a complex process, nonetheless, it’s a crucial process that needs to be undertaken to ensure
Business Deal Deals are made daily between different parties who share a common interest in different aspects of life. This interest could be in hobbies, art, music, and many other