What is Cost of Revenue?
The term “cost of revenue” encompasses all expenses associated with producing and delivering a product or service to consumers. This crucial financial data is typically disclosed in a company’s income statement, aiming to represent the direct expenditures linked to the goods and services provided by the company. The service industry commonly employs the cost of revenue metric due to its comprehensive nature, encompassing various costs associated with selling a product or service.
Key points:
- Cost of revenue encompasses all expenses related to manufacturing and delivering products or services to consumers.
- This information is typically disclosed in a company’s income statement.
- The service industry often prefers this metric because it covers various costs associated with selling products or services comprehensively.
- Unlike the cost of goods sold, the cost of revenue also includes external production costs like distribution and marketing.
- Examples of cost of revenue components include cost of goods sold, warranties, returns, shipping, and commissions.
How Cost of Revenue Works
The cost of revenue embodies the entirety of expenses involved in manufacturing and vending a product or service. This encompasses all production-related costs like raw materials, labour, and overhead expenditures, along with any other direct expenses linked to producing and distributing the offering.
Understanding the cost of revenue is crucial for businesses as it aids in ascertaining the genuine gross profit margin. Companies aim to determine the remaining revenue after covering all expenses associated with producing and marketing a product. This residual profit is allocated to cover essential overhead or indirect costs crucial for the company’s operations but not directly linked to the product manufacturing process.
How to calculate Cost of Revenue
The formula for calculating Cost of Revenue is relatively straightforward. It can be expressed as:
Cost of Revenue = Cost of Goods Sold + Shipping Costs + Commissions + Warranties + Returns + Other Direct Costs
Note: Cost of Revenue isn’t Generally Accepted Accounting Principles (GAAP)-approved and doesn’t appear on publicly-issued financial statements.
What is included in Cost of Revenue
Direct Materials
Materials directly used in production, known as direct materials, encapsulate the expenses incurred for raw materials necessary in crafting a product. This category commonly covers shipping or handling costs linked to obtaining these materials, forming a part of the cost of goods sold within the overall cost of revenue.
Direct Labour
Direct labour pertains to remunerations, including wages, salaries, and benefits, directed to employees directly engaged in producing or delivering a product or service. Some companies can directly allocate payroll expenses of particular employees to specific product lines, often requiring an allocation process, especially for those employees working across multiple product lines. These expenses are also incorporated into the cost of goods sold within the cost of revenue.
Manufacturing Overhead
Manufacturing overhead encompasses unavoidable costs necessary for production, albeit not directly traceable, such as utilities or equipment maintenance. These overhead expenses are typically reported as part of the cost of goods sold.
Freight and Shipping
Freight and shipping costs represent the expenses incurred in transporting finished products to customers or retailers. These costs are integral to the cost of revenue as they are indispensable in distributing goods as part of a sale, ensuring products reach their destination for customers or retailers. Hence, they are unavoidable expenses.
Duties and Taxes
Duties and taxes, often imperative for international distribution of goods involving import or export requirements, become part of the cost of revenue. While companies can opt not to distribute to regions incurring these costs, once distribution commitment is made, these expenses become essential.
Returns and Warranties
Returns and warranties account for expenses related to goods not retained or allowances granted to customers, covering aspects like shipping costs or restocking fees. Additionally, costs may arise during products’ warranty periods and are considered part of the cost of revenue, given that customers might have been influenced to purchase due to the warranty period.
Commissions
Commissions disbursed to sales agents, distributors, or intermediaries involved in product sales are directly associated with the product and often included in the cost of revenue. These commissions serve as incentives that contribute to the sale of goods and are linked to the product’s sales performance.
Other Direct Costs
Furthermore, specific to individual product lines or industries, there exist other direct costs unique to particular companies, necessitating inclusion within the cost of revenue due to their direct association with the product line or industry at hand.
What is Cost of Goods Sold (COGS)?
The Cost of Goods Sold (COGS) is the main tally of expenses a company incurs in producing its goods and later selling them during a specific period. However, COGS may be easily confused with the cost of revenue.
Cost of Revenue vs. COGS
The cost of revenue differs from the cost of goods sold (COGS) by encompassing expenses beyond production, encompassing distribution and marketing. It comprises the COGS or service costs along with supplementary expenses essential for generating sales.
While the cost of revenue incorporates numerous sales-related expenditures, it does not factor in indirect costs like managerial salaries. Expenses included in the cost of revenue span various items, including labour, commissions, materials, and sales discounts.
Comparing profitability metrics using standard formulas like those found in income statements, a profit margin calculated based on the cost of revenue would yield a lower value than those typically employed incorporating quarterly reporting. This discrepancy arises due to the inclusion of COGS or service costs and other direct expenses.
The contribution margin encompasses all variable costs, while the gross margin solely considers COGS or service costs. A company exhibiting a low percentage of cost of revenue to total revenue signals robust financial stability and potentially robust sales performance.
Examples to Determine Cost of Revenue
To better understand how Cost of Revenue works in practice, let’s look at a few examples.
SaaS Company
Consider a Software as a Service (SaaS) company. Their Cost of Revenue would include not only the expenses related to developing and maintaining the software but also the costs of customer support, hosting, and data centre operations. Delivery costs might be minimal, but support costs, including technical support and user training, could be significant. However, some SaaS vendors also factor Cost of Revenue as the sum of COGS and delivery costs, such as providing demo units to a potential client.
Retail Business
In contrast, a traditional retail business would primarily focus on COGS, which includes the cost of purchasing inventory, storing it, and the direct costs of selling the products. The Cost of Revenue in this case might be minimal, limited to delivery costs and perhaps some minimal post-sale support.
Auto Manufacturer
For an automobile manufacturer, Cost of Revenue covers the expenses related to producing and delivering vehicles, including the production costs of the car, transport to dealerships, and customer support during the warranty period (overhaul, OEM parts, tuning, etc). This comprehensive view of costs gives the company insights into the true expenses involved in revenue generation.
Conclusion
Cost of Revenue is essential for businesses aiming to accurately assess profitability and operational efficiency. It reflects the direct expenses incurred in generating revenue, encompassing the production costs and the costs associated with product delivery and post-sale support.
While Cost of Revenue shares similarities with the more familiar Cost of Goods Sold (COGS), the differences between the two are significant, with Cost of Revenue having a broader scope. By accurately calculating and understanding Cost of Revenue, businesses can gain a more comprehensive perspective of their operations and make informed decisions to enhance profitability and customer satisfaction.
DISCLAIMER: This article is for informational purposes only.