Cost recovery is an accounting principle in which a business recognizes revenue from a sale only after the cash element of the sale has been collected from the customer in cash. It is a method of recording income that differs from the installment method in which revenue is recognized as each payment is received rather than all at once. It is appropriate for cases where the probability of receiving full repayment from a client is not guaranteed.
The process of determining cost recovery is one that takes into account the amount the company actually incurs in producing a product or performing a service. This includes direct costs, such as labor and materials, as well as indirect expenses, such as space rental, utilities and postage. This information is then compared to the amount the company has charged to its clients for the product or service produced. A percentage of this difference is then recorded as the profit margin.
For example, a company might have sold goods and services to Gilbert for $ 100,000. If the company used the installment method, it would record $ 100,000 of gross revenue and $100,000 in cost of goods sold on its books. However, if the company opted to use the cost recovery method of accounting, it might only record $ 100,000 of revenue and $1,000,000 in cost of goods sold on its books. Only after Gilbert has made payments equaling $100,000 in total or more than that amount will the company recognize that it has earned a profit of $1,000,000.
Typically, companies follow the cost recovery method to avoid overstating net income. For instance, if a company booked all of its profits in year one and Gilbert did not make any payments in subsequent years, the company could overstate its net income and owe taxes the following year. For this reason, it is important to keep track of how much income has been paid and to subtract that amount from the overall project costs to quantify gross profit.
As a government entity, it is important to ensure that we do not overcharge taxpayers for activities that are necessary and beneficial to the community. Some examples of activities that may be considered to be cost recoverable include increasing property values, providing safety and security, addressing social needs and enhancing quality of life. These types of activities are usually covered by taxes, and if the organization wishes to charge a fee for these services, it is often best to do so at a minimal rate to limit the potential for overcharging.
The Office of Budget and Financial Management is responsible for reviewing our cost recovery policy biennially, updating it as needed and ensuring that all reimbursable agreements set up in SAM comply with the policy. The Office also reviews requests for permanent exceptions to the policy and recommends approval or denial based on servicewide impacts. If you are interested in requesting a permanent exception to the cost recovery policy, please contact the Reimbursable Agreement Operations team.