Nordale Systems: Allocating a Bundled Machine, Installation, Support, and Renewal Option
On November 1, 20X5 Nordale Systems contracted to deliver a sorting machine, install it, and provide four years of remote monitoring support for a fixed $1,200,000, payable in full on delivery. Nordale frequently sells the machine alone for $950,000 and regularly sells installation for $100,000 and four-year support for $400,000. Installation requires Nordale's proprietary calibration software and cannot be performed by third parties; the machine cannot operate to specification until calibration is complete. The machine was delivered and installation accepted on November 15, 20X5; support began November 1, 20X5. The contract also lets the customer buy two additional years of support at a 25% discount off standalone price; Nordale's standalone price for two years is $200,000 and it expects the customer to exercise the option. Nordale may earn a $150,000 bonus if throughput exceeds 10,000 units per hour; the best test result was 8,700 units per hour and Nordale has no history with this model.
1. Identify the performance obligations in the contract, addressing specifically whether installation is distinct and whether the renewal option is a separate performance obligation.
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Machine and installation: one combined performance obligation. The two criteria for distinctness fail:
- Capable of being distinct - the machine does not function to specification without the calibration, and no third party can perform it, so the customer cannot benefit from the machine on its own.
- Distinct within the context of the contract - the calibration is a significant integration service that produces a combined output, and the installation price is highly interdependent with the machine. Combine them and allocate the combined amount using the sum of the two standalone prices ($950,000 + $100,000 = $1,050,000).
Support: a separate performance obligation. The customer benefits from monitoring over four years, it is routinely sold separately, and it does not modify or integrate with the machine.
Renewal option: a material right, and therefore a separate performance obligation. The customer could not get a 25% discount without entering this contract. The right is measured at the discount the customer would not otherwise receive: 25% x $200,000 = $50,000, adjusted for the likelihood of exercise. Because Nordale expects exercise, no probability reduction applies. Had the option been priced at standalone selling price, no material right would exist and no allocation would be made.
Note the allocation consequence: the $50,000 is an obligation that must be funded out of the same $1,200,000, so it reduces the amount allocated to the machine and the support - it does not create incremental revenue.
2. Allocate the $1,200,000 transaction price and compute revenue recognized for the year ended December 31, 20X5 and the deferred revenue balance.
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Step 1 - Allocate on relative standalone selling price
| Performance obligation | Standalone price | Allocation |
|---|---|---|
| Machine + installation | $1,050,000 | $1,200,000 x 1,050/1,500 = $840,000 |
| Four-year support | $400,000 | $1,200,000 x 400/1,500 = $320,000 |
| Renewal option (material right) | $50,000 | $1,200,000 x 50/1,500 = $40,000 |
| Total | $1,500,000 | $1,200,000 |
Step 2 - Recognize
- Machine + installation: transferred on November 15, 20X5 when the customer accepted installation (control passed at that point, not on delivery alone). Recognize $840,000 in 20X5.
- Support: straight-line over 48 months beginning November 1, 20X5. Two months elapsed: $320,000 x 2/48 = $13,333 in 20X5.
- Renewal option: recognize when the option is exercised or expires. $0 in 20X5.
20X5 revenue = $840,000 + $13,333 = $853,333. Deferred revenue at December 31, 20X5 = ($320,000 - $13,333) + $40,000 = $346,667. Check: $853,333 + $346,667 = $1,200,000.
Judgment to document: the 48-month period starts when the support is available (November 1), not when the machine is accepted. A common error is starting support on November 15, which would change the 20X5 amount slightly and is not the substance of the arrangement.
3. Evaluate the $150,000 throughput bonus. How does the constraint apply, and what happens if testing in 20X6 demonstrates the target is achievable?
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Most likely amount, not expected value. The bonus is a binary outcome, so the entity applies the most likely amount approach to the single contract.
Constraint analysis under the 'probable of no significant reversal' test:
- The target requires 10,000 units per hour against a best-ever test of 8,700 - a 15% gap.
- Nordale has no history with this model.
- The bonus depends on customer-controlled operating conditions after delivery, which further reduces Nordale's ability to influence the outcome.
- The potential reversal is material relative to the contract (12.5% of the transaction price) and would reverse all at once, in a single period.
Conclusion: constrain the variable consideration to $0 at inception and at December 31, 20X5. The $1,200,000 allocation above is therefore the full transaction price.
Two refinements worth raising. First, the bonus is tied to machine throughput, so any amount that becomes probable is allocated entirely to the machine-and-installation obligation rather than spread across the contract. Second, the constraint is reassessed at each reporting date: if 20X6 testing clears 10,000 units per hour, the promised amount changes and the cumulative catch-up is recognized at that time - a change in the transaction price, not a change in estimate requiring the modification model. Conversely, a change in the estimate of the constraint that results from a change in the contract's terms would be a modification, which is a different analysis.