What Is Cost of Revenue? (And How to Calculate It)
Updated September 30, 2022
Understanding what the cost of revenue (COR) is and how you can determine it is a valuable financial skill in the business industry. Companies often benefit from calculating this cost because it helps them manage assets and optimize their spending. Familiarity with these expenses and types of revenue can help you accurately calculate this cost and reference it with other statistics to inform business goals. In this article, we discuss what the cost of revenue is, develop an understanding of revenue and its different types, and review how to calculate it with an example.
What is the cost of revenue?
The cost of revenue is the sum of costs incurred by a company to produce, manufacture, and distribute its goods or services to consumers. The term refers to total costs for delivering a product or service to a customer. Companies register these costs in the company income statement to represent the direct costs associated with providing their product. This number offers a more accurate calculation of the costs associated with selling services, so it is usually applicable for companies that provide services like IT support.
What is an income statement?
An income statement, sometimes called a profit-and-loss statement, shows a company's profitability over a specific time period. It is a fundamental document in many companies' financial reporting. This document summarizes revenue and expenses that resulted from operating and non-operating activities and shows the company's net profits and losses. Income statements can take two approaches, a cash or accrual basis. Owners, managers, and financiers use these statements to compare a company's business plan with their results for an operating period and make adjustments to improve business performance accordingly.
What to include in the cost of revenue
The COR for companies that sell a product usually differs from a company that sells services. The components of COR for a product company are:
Direct labour: An organization, regardless of its specialties, requires a workforce to deal with production and other aspects of the business like finance, administration, marketing, and legal departments. The salaries of employees involved directly with manufacturing count as labour costs.
Direct material: Businesses that produce products require several primary resources and components to construct their product. The costs of these materials, which may include raw materials, consumables, and semi-finished parts, are included in direct material costs.
Distribution costs: Costs incurred while taking products from a manufacturing line to the final customer or distribution center become distribution costs. These include freight charges, handling charges, insurance fees, and storage costs, along with any other expenses related to transport.
Direct expenses: Expenses incurred while companies produce goods have other costs linked to the manufacturing process. This often includes a variety of commissions.
Marketing costs: Any advertising and agency fees directly linked to their products can contribute to these cost calculations.
Other costs: All other costs that can directly affect the manufacturing of a product or its distribution to the consumer get included in COR calculations.
The components of COR for service-based business include:
Direct labour: Similarly to manufacturing companies, service-based companies require employees. These organizations sell services instead of a tangible product, so their workforce is an important asset, and funds spent on salaries, recruiting, and other employee-related expenses contribute to these labour costs.
Marketing costs: Service-based and manufacturing companies have different ways of targeting audiences, but their marketing costs are often similar to product-based companies.
Direct expenses: Service-based companies incur direct expenses with various pieces of equipment required to provide the services they sell.
Other costs: Any other costs that can directly relate to delivering the services to the client get included in COR calculations.
Cost of revenue vs. cost of goods sold
The key difference between COR and the cost of goods sold (COGS) is that the former relates to the production and other aspects of product or service delivery to the customer. COGS is the total direct cost of producing or creating a product or a service. The formula for COGS is:
Starting inventory + purchases during a specific period − end inventory
This usually helps when comparing profit measures. Using a formula for profit margins, like those listed in an income statement, creates a profit margins measure based on revenue costs generates a lower value. This is because it includes the costs of goods sold and other direct costs. A contribution margin includes total variable costs, whereas the gross margin includes only the cost of goods sold. A company with low revenue costs to total revenue percentages shows it is financially stable and has strong sales.
Understanding what revenue is can allow you to better understand how to calculate it. Revenue is any money generated from standard company operations. Companies calculate it as the average sales price multiplied by the number of units sold. Applied to gross income, this is the top-line figure, and they use it as a baseline to calculate income on an income statement. Another part of calculating revenue is the cash flow statement.
A cash flow statement is a financial statement showing changes in accounts and income. Checking the cash flow statement is necessary to assess how efficient a company is at collecting money owed to them by vendors or other businesses. Cash accounting only counts sales as revenue after the accountant receives the payment. Any money paid to a business is often a receipt, and it is possible to have receipts without revenue. The reason revenue is the top line is that it appears first on the company's income statement.
Types of revenue
Revenue is sub-divided into the divisions that generate it. An example is operating revenue, which is sales from a company's core business, and non-operating revenue derived from secondary income sources. The non-operating revenue is often unpredictable and non-recurring, so companies sometimes consider them onetime events or gains. An example of this could be proceeds from the sale of a particular asset or unexpected payouts from a previous investment.
Tips for calculating the COR
Consider these tips to calculate the COR:
Choose a period. Choose which quarter you want to analyze (Q1, Q2, Q3, or Q4.)
Determine the beginning inventory values. Review the total cost of all goods or services sold and produced during the chosen time period. Include the closing inventory at the end of the period.
Include all costs. Calculate the COR considering whether the business sells goods or services.
Calculate the costs. Include the cost of production and starting inventory and subtract the ending inventory. The result is the COR for the respective period.
Look at these examples of how to calculate revenue costs for a certain time period:
A manufacturing company produces tennis shoes. Their total revenue is $200,000 for one quarter. In this same period, their cost of goods sold is $40,000, their labour costs are $15,000. Their marketing expenses total $10,000, rental costs are $40,000, and overhead expenses total $20,000. Determining the cor involves adding all these elements. This calculation is:
40,000 + 15,000 + 10,000 + 20,000 = $85,000
The company excludes the rental costs because they relate indirectly to the manufacture or sale of the product. Considering that the total revenue is $200,000, the revenue costs to revenue percentage is 42%.
Assuming Company X sells electronic equipment and offers repair services for their equipment. It reports a total of $100 million in revenue. Their cost of goods sold is $15 million and services sold $7 million. With direct labour costs of $5 million, marketing costs of $1 million, and overhead costs of $3 million, they also pay $10 million to its management and rental costs of $8 million.
With this information, you can determine the company's revenue costs of $31 million for the fiscal period. Consider the $10 million for salary management and the rental fees of $8 million indirect costs. Since Company X had total revenue of $100 million, they have a revenue margin of $100 million. The company has a revenue cost to total revenue percentage of 31%, which is $31 million divided by $100 million.
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