Why is the Cost Recovery Method Generally Followed in Accounting?

This article aims at explaining the cost recovery method in accounting, along with an example. Read to know all about this important accounting technique.
BusinessZeal Staff
Last Updated: Jun 3, 2018
The business environment is getting more and more challenging these days, with many competitors in the market. Expectations of the buyers have grown over the years and this has forced many companies, big and small, to change their approach and introduce new accounting measures.

Cost Recovery Convention of Accounting

The concept states that the business enterprise should not consider any income until it has fully recovered the cost of selling any product to its customers. This means that the gross profit of a firm would be more if it has managed to recover all its pending dues from the customers or clients. This method in accounting helps the firms play safe and not make any illogical and over-optimistic judgments about their profitability and total sales. The companies following this technique of accounting are aware of the ground reality and hence they are bound to do well in the future. This method helps in discounting all those factors which are negative for any business.

This method is used, considering the changing financial position of the customers and their ability to pay. Revenue may be quickly realized in the case of some cash-rich or high-budget clients. However, some clients may take more time for complete payments and unless all the money is recovered, it cannot be included in the profits made during a period.

Example

Let us assume that you are running a furniture supplying company. You have many customers who are giving you orders for furniture items for many years. How are you going to recognize the receipt of revenue? Consider the information given below to know this.

Your sales revenue for furniture items: USD 16,000
Total cost of sales: USD 8,000
Gross profit: USD 8,000
Initial amount received from the client: USD 2,000

From the above case, it is clear that you have been paid USD 2,000 as the down payment for the supply of furniture items by the client. However, the gross profit shown above is not recognized or considered unless you recover the remaining USD 6,000, and the entire cost of sales.

This method is more related to the facts and present situation of the business and gives more importance to received cash or money, than the amount which we will be getting eventually. Any business person would be able to know the exact valuation of his firm or the extent, profits, and sales volumes of his business with the help of this method. Apart from this, the firm needs to implement well-known strategies to reduce the expenses and increase profit margins. Fast and successful expansion policies can ensure consistent growth in sales. With this optimistic approach, business firms will be able to achieve their set targets and provide better guidance and returns to their investors, in the days to come.