Understanding The Cost of Revenues
By Lior_Ronen | Founder, Finro Financial Consulting
As a business owner or manager, you're probably familiar with the term "cost of revenue."
In fact, you probably use this phrase regularly when creating your financial projections, discussing pricing strategies, profit margins, and other financial matters.
But what is the cost of revenue? What exactly does it mean to calculate the cost of revenues? How does it affect your financial forecast? And how can you use this information to help your company succeed?
First things first: The cost of revenue refers to all expenses related to producing or providing goods or services.
This includes direct costs like labor and materials as well as indirect costs such as overhead expenses (rent, utilities) that aren't directly tied to specific units produced but rather support overall operations.
The cost of revenues is an income statement component that, together with the revenues, comprises the company's gross profit.
As a general rule, the cost of goods sold (COGS) and the cost of revenues are separate line items on an income statement. But in many cases—specifically in the tech industry—these differences are so slim that they don't exist at all.
The cost of revenues includes two primary components: direct and indirect costs. As a whole, these components give you a comprehensive overview of the total cost required to produce, distribute and deliver your products or services.
Knowing how the different components of the cost of revenue can help small business owners and managers in large corporations understand their financial statements and improve financial planning and cash flow projections for the business.
What are direct costs?
Direct costs are those costs that can be directly attributed to a specific product or service. They are usually fixed in nature, meaning they stay the same regardless of how much is produced.
They usually have a direct dollar value associated with them, making it easy to calculate their cost per unit of output.
Direct costs can be broken down into two categories: fixed and variable.
Fixed costs remain constant regardless of how much of an item is produced (e.g., rent on your warehouse space). Variable costs increase as more units are produced (e.g., raw materials).
What are indirect costs?
Indirect costs are associated with the production and sale of your company's products or services but aren't directly associated with a specific type of product. Examples of indirect costs include rent, utilities, payroll, and insurance.
While these expenses can be challenging to measure separately from your direct revenue-generating activities, understanding them will help you make better business decisions.
Calculating the gross margin
Gross margin is a derivative of the gross profit.
Gross profit is the amount of money a company keeps after paying for the costs of making and selling its products and providing its services to customers.
Gross profit is the difference between a company's revenues and its cost of goods sold, or COGS.
To calculate gross profit, subtract your cost of revenue from your revenue. Then, divide the gross profit by the revenue to get your gross margin.
By calculating the gross margin, a company or an external analyst can:
Compare companies' gross profitability and take the revenue size out of the equation.
Understand how many cents the company retains from every dollar it generates in sales.
Here's a simple example for calculating the company's gross margin.
Assume you sell a product for $10 that costs $8 to produce, and sell 10 of them.
Revenue = 10 * $10 = $100
Cost of revenue = 10 *$8 = $80
Gross profit = $100 - $80 = $20
Gross margin = $20 / $100 = 20%
Or you can calculate the gross margin directly. Your gross margin would be ($10 -$8)/$10 = $2/product or 20%.
The cost of revenues affects gross margin and, ultimately, the health of your business.
To understand the health of your business and whether or not you’re making money, it’s essential to look at both your revenue and your cost of revenue.
The cost of revenues is basically all of the costs associated with getting your product or service out there for sale. The cost of revenues can include things like materials, labor costs, shipping fees, marketing expenses, etc.
If you have a physical product like a t-shirt or coffee mug, then some portion of its cost goes into designing it to look good in person and sell well online.
Then another portion goes into manufacturing those products on an assembly line overseas where they're made cheaply (but not always with great quality).
If there's any leftover space left over after everything else has been covered, then maybe some profit gets cut off at the last minute before sending out an invoice!
Conclusion
We hope this article helped clarify the cost of revenues and its importance.
If you have any questions or would like to learn more about other aspects of financial reporting, feel free to drop us a line!
