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.

How is the cost recovery method applied and examples?

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.

Advantages & limitations of the cost recovery approach

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.

1. It is simple to understand. Once it is applied or when you go through its basics, applying it is not a complicated task, and realizing its value based on your business nature could be evident.
2. It is most suitable for businesses that have activities in manufacturing of goods or offering services, in other words businesses that rely on inventory and cash existence.
3. The recovery of costs of goods sold (COGS) and the collection of revenue will clarify the measurement of profit.
4. Businesses that sell products and services on a cash-account basis can be used.
5. Can be used:

• by businesses that sell products and services on a credit-account basis.
• for short-term or long-term transactions.
• by sellers or buyers.
  • for gross and net profit calculations.
  • to direct and indirect costs.
  • to specify if a transaction should be recorded.
  • to specify if an existing transaction should be recorded.
  • for products and services transactions.

1. It doesn’t need the calculations of a projected profit.
2. It does not need the creation of a projected balance sheet.
3. It does not need the creation of a projected cash flow statement.

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:

1. Businesses that make or create products and services are the only businesses that can apply this approach.
2. It can only be used by businesses that offer goods and services on a cash-account basis.
3. It can only be used or applied by businesses that offer their goods and services on a credit-account basis.
4. It cannot determine for you the correct timing of revenue recognition.
5. It cannot determine the correct revenue recognition for a product or a service sold on credit.
6. It does not account for the risk of non-payment or defaults.

Final take

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:

1. Measure Your product Costs

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.

1. Monitor the flow of revenue

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.

1. Specify your profits.

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.

Example for clarifications

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.

• The sale provided to Mr. K on November 1, 2019, = $350,000
• Cost of the goods sold = $300,000
• Sum received upfront for the sale = $50,000

Left over of the payment in installments is:

• Amount received in 2020 = $50,000
• Amount received in 2021 = $100,000
• Amount received in 2022 = $50,000

Now we could ask ourselves: When will the company acknowledge the profits in relevance to the cost recovery approach?

What is the solution?

According to the cost recovery model and the payments made so far  by the company, the present situation would be like this:

• The $50,000 is the profit for the company, which is generate from (Sale-Cost): ($350,000 – $300,000)
• The made profit can’t be specified in the period when the sale was conducted. On the other hand, it will be recognized when it becomes the payment after recovering the cost of the sold goods.
• Total payment received the following years 2020, 2021, and 2022= ($50,000 + $100,000 + $50,000). This is the cost of the goods sold. Hence, the company will not record any earnings.
• Finally, the amount received in 2022 ($50,000) will be recorded as income.

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:

• This approach is a revenue recognition approach in accounting in which a businessman or staff recognizes a return from a sale transaction only when the cost factor of the sale has been retrieved from the buyer in cash.
• Revenue recognition is one of the major processes in accrual accounting and is a generally recognized accounting fundamental that recognizes when income is switched into revenue.
• Cost recovery approach can be applicable once there is an uncertainty of collecting the costs associated with the sales or when the provider cannot elaborate an installment plan or where the seller is not capable of arbitrating the sale value specifically.
• Collecting or recovering a business expense, or recovering the cost of a business-related expenses, creates the foundation for cost recovery.

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