The term cost of revenue is used by a business to refer to the total costs necessary to generate a sale. It is similar in nature to the cost of goods sold except that the cost of goods sold only includes costs prior to the sale, whereas cost of revenue also includes some additional costs necessary to complete the sale transaction.
As an example, credit card charges incurred by a retailer when selling a product to a customer would be included in the cost of revenue as they were necessary to make the sale, but would be excluded from the cost of goods sold calculation.
Furthermore cost of revenue tends to be used by service businesses who have less use for the cost of goods sold concept as they do not hold inventory and do not need to be concerned with its valuation.
Cost of Revenue Formula
The costs to be included in cost of revenue vary from business to business depending on the type of industry in which they operate. They of course include the traditional cost of goods sold costs such as production, manufacturing and product purchase costs, but also selling, marketing, and distribution costs which can be directly attributable to the sale.
There is considerable flexibility in deciding which costs to include in the cost of revenue, and although the following lists are not exhaustive, they hopefully give an indication of the type of costs which should be included.
Cost of Revenue in a Service Based Business
In a traditional service based business, the cost of revenue is likely to include the following types of cost.
- Wages, salaries and personnel costs for staff delivering the service
- Subcontracting costs
- Costs of research
- Photocopying, and production of presentations and reports
- Allocated overhead
- Cost of promotions related to the sale
- Sales commissions
- Purchase returns, discounts and allowances
Cost of Revenue in an Internet Based Business
In an internet based business, particularly one where there is no physical product or inventory, it is normal to arrive at a cost of revenue by including costs such as energy and bandwidth costs, and data center operation costs, as these can be directly attributed to the generation of the revenue.
The following examples show the variation in the types of cost included in the cost of revenue by different types of internet based businesses.
Facebook Cost of Revenue
- Delivery and distribution
- Data centers lease and hosting costs
- Facility and server equipment depreciation
- Facility and server equipment rent expense
- Energy and bandwidth costs
- Support and maintenance costs
- Operations teams salaries, benefits, and share-based compensation
- Credit card and other transaction fees related to processing customer transactions
- Amortization of intangible assets
Etsy Cost of Revenue
- Data centers lease and hosting costs
- Energy and bandwidth costs
- Support and maintenance costs
- Depreciation of servers and networking equipment
- Operations teams salaries, benefits, and share-based compensation
- Cost of interchange and other fees for credit card processing services
- Credit card verification service fees and credit card charge-backs
- Costs of refunds made to buyers
Twitter Costs of Revenue
- Data centers lease and hosting costs
- Energy and bandwidth costs
- Support and maintenance costs
- Depreciation of servers and networking equipment
- Operations teams salaries, benefits, and share-based compensation
- Allocated facilities and other supporting overhead costs
- Amortization of intangible assets
- Amortization of capitalized labor costs
Alibaba Costs of Revenue
- Payment processing fees
- Traffic acquisition costs
- Website operation costs such as bandwidth and hosting
- Depreciation and maintenance expenses for computers, servers, call center and other equipment
- Salary, bonuses, benefits and share-based compensation expense relating to customer service, web operation personnel, and payment processing consultants
- Unit-volume driven rebates
- Business taxes and related surcharges
- Allowance for doubtful accounts in relation to the micro loans
EA Games Costs of Revenue
- Product costs
- Royalty expenses
- Manufacturing royalties
- Expenses for defective products
- Write-offs of post launch prepaid royalty costs
- Amortization of intangible assets
- Personnel-related costs
- Warehousing and distribution costs
- Data center and bandwidth costs associated with hosting of online games and websites
- Credit card fees
- Server costs related to website platforms
- Processing fees from operating website-based games on third party platforms
Red Hat Costs of Revenue
- Support, distribute, and package enterprise offerings
- Labor-related cost to provide technical support
- Security updates and fixes
- Costs for fulfillment
- Physical media
- Literature
- Packaging and shipping
- Personnel and third-party consulting costs for the design, development and delivery of custom engineering
- Training courses and professional services provided to customers
Microsoft Costs of Revenue
- Manufacturing and distribution costs for products sold and programs licensed
- Operating costs related to product support service centers and product distribution centers
- Costs incurred to include software on computers sold by OEMs
- Website traffic acquisition costs
- Costs to support and maintain internet-based products and services
- Royalty costs
- Warranty costs
- Inventory valuation adjustments
- Costs associated with the delivery of consulting services
- Amortization of capitalized research and development costs
Calculating the Gross Margin % Using the Cost of Revenue
Irrespective of whats included in cost of revenue, the calculation of the gross margin percentage for use in the financial projections template is always the same.
| Account | |
|---|---|
| Revenue | 120,000 |
| Cost of revenue | 54,000 |
| Gross margin | 66,000 |
To illustrate, in this example the gross margin is 66,000/120,000 = 55%. As can be seen for a given revenue, the higher the cost of revenue the lower the gross margin percentage of the business.
Cost of Sales vs Cost of Revenue
To allow for flexibility in the financial projections template the term cost of sales is used on the income statement to refer to either the cost of goods sold or the cost of revenue, depending on the type of business and the manner in which the gross margin percentage has been calculated.
While for a non-inventory type business this is a matter of choice, for an inventory based business, such as a manufacturer or retailer, this line should refer to the cost of goods sold as it is used later in the valuation of inventory on the balance sheet.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.