What Is Cost of Revenue?

The term cost of revenue refers to the total cost of manufacturing and delivering a product or service to consumers. Cost of revenue information is found in a company's income statement. It is designed to represent the direct costs associated with the goods and services the company provides. The service industry often favors using the cost of revenue metric because it is a more comprehensive account of the various costs associated with selling a good or service.

How Cost of Revenue Works

Cost of revenue is the total cost incurred to produce and sell a product or service. It includes all the costs associated with the production process, such as raw materials, labor, overhead expenses. It also includes any other direct costs related to the production and delivery of the product or service.

Cost of revenue is important for businesses because it helps them determine their true gross profit margin. Companies should be interested in know how much residual revenue is left over after all costs of making and selling a product have been incurred. This residual profit is used to pay overhead or indirect costs still vital to the operation of the company but not directly tied to making a product.

Formula and Calculation of Cost of Revenue

The formula for the cost of revenue is:

Cost of Revenue = COGS + Shipping Costs + Commissions + Warranties + Returns + Other Direct Costs

To calculate cost of revenue, it's important to first decide what period to use. Many companies will calculate cost of revenue on a monthly or quarterly basis to use for decision-making during the course of the year. Another important aspect of calculating cost of revenue is determine what the beginning inventory was at the beginning of the period. This figure is required because it is an integral part of calculating the cost of goods sold. Last, companies need to be mindful of the "other" category. Depending on the nature of the company, the product line may have a diverse set of direct costs. Not every company will have the same direct costs, and these direct costs may change from one period to the next as a company evolves its manufacturing process.

What Is Included in Cost of Revenue

As mentioned before, every company's direct costs and cost of revenue may be calculated differently. Here's a broad range of what is included in the cost of revenue, though not all of these costs may be relevant and other direct costs not included in this list should be included.

Direct Materials

Direct materials are the costs of raw materials used in the production of a product. Direct materials often include any shipping or handling costs associated with acquiring these materials. Direct materials are included in the cost of goods sold component of the cost of revenue.

Direct Labor

Direct labor is the costs of wages, salaries, and benefits paid to employees directly involved in the production or delivery of the product or service. Companies may directly trace the payroll costs of specific employees to product lines, though this often entails an allocation process (especially for those employees who may work on different product lines). Direct labor is also included in the cost of goods sold component of cost of revenue.

Manufacturing Overhead

Sometimes, there are costs a company simply can't directly trace. However, these costs are still necessary for the manufacturing of a product. Manufacturing overhead includes all non-directly associated costs of the production process such as utilities or equipment maintenance. These are also usually reported as part of the cost of goods sold.

Freight and Shipping

Freight and shipping are the costs of shipping finished products to customers or retailers. These are included in the cost of revenue because they represent expenses necessary to distribute goods as part of the sale. Without these expenses, customers and retailers would be unable to receive the products, so these costs can often not be avoided.

Duties and Taxes

In a similar manner, duties and taxes may be required to distribute a good. This is especially true for goods being distributed internationally that require importation or exportation. Though companies can choose to not distribute to these regions, these costs are often avoidable once a company commits to distributing to a region.

Returns and Warranties

Returns are costs associated with good not kept or allowances given to customers such as shipping costs or restocking fees. Companies may expect that a certain percentage of goods will be returned as the normal course of business. In addition, companies may incur costs while products are under a warranty period. These costs may be considered a cost of revenue because customers may be have been incentivized to buy a good partially because of the warranty period.

Commissions

Companies may pay commissions to sales agents, distributors, or other intermediaries involved in the sale of the product. These commissions are often directly related to the product and not broadly related to the company. As long as these costs can be tied to a product, companies often include them in the cost of revenue because goods were often sold due to this extra incentive awarded to sellers.

Other Direct Costs

As mentioned before, companies have very different structures from one another. There are often other direct costs unique to a specific product line or industry that necessitate inclusion into cost of revenue.

Cost of Revenue vs. Cost of Goods Sold

Cost of revenue is different from cost of goods sold (COGS) because the former also includes costs outside of production, such as distribution and marketing. The cost of revenue takes into account the cost of goods sold (COGS) or cost of services provided plus any additional costs incurred to generate a sale.

Although the cost of revenue factors in many costs associated with sales, it does not take into account the indirect costs, such as salaries paid to managers. The costs considered part of the cost of revenue include a multitude of items, such as the cost of labor, commission, materials, and sales discounts.

When comparing profit measures using a standard formula for profit margins such as those listed in an income statement, creating a profit margin measure based on the cost of revenue would generate a lower value than those typically used by corporations for quarterly reporting. That's because it includes the COGS or cost of services and other direct costs.

The contribution margin includes total variable costs, and the gross margin only includes the COGS or the cost of services. A company with a low cost of revenue to total revenue percentage indicates that it is in stable financial health and may have strong sales.

Cost of Revenue Example

Here's a hypothetical example of how the concept of cost of revenue works. Let's assume XYZ Inc. sells electronics products and offers services to repair electronic equipment. The company reports total revenue of $100 million, COGS of $15 million, and cost of services sold of $7 million. The company has direct labor costs of $5 million, marketing expenses of $1 million, and direct overhead costs of $3 million. XYZ also pays $10 million to its management and records rental costs of $8 million. We can determine from this information that the company's cost of revenue is $31 million for the fiscal period. The $10 million paid to its management and the rental costs of $8 million are indirect costs, which are not included in the cost of revenue. Since the company had total revenue of $100 million, XYZ Inc. has a cost of revenue margin of $100 million ($31 million = $69 million.) Moreover, the company has a cost of revenue to total revenue percentage of 31%, or $31 million divided by $100 million.

The Bottom Line

Cost of revenue is the total cost incurred to produce and sell a good. It includes the cost of goods sold in addition to all sorts of other cost sof production. It also includes costs not included in production but needed to deliver or market a product. All of this information is used by a company to better understand the true profit margin of a product.