By Adam Hoeksema
When it comes to a service business, Cost of Goods Sold (COGS) doesn’t quite make sense. If you want to be precise, COGS is only used for product based businesses.
So what if you operate an IT service company, what is your COGS? What if you develop and sell software, what is your COGS?
Rather than using the term cost of goods sold, it would be best to use a similar term — Cost of Revenue.
Cost of Revenue for Service Based Businesses
Now I want to dive deep into exactly what Cost of Revenue is and what it is not. I also want to help you determine your cost of revenue on a per unit basis.
“The total cost of manufacturing and delivering a product or service. Cost of revenue information is found in a company’s income statement, and is designed to represent the direct costs associated with the goods and services the company provides. Indirect costs, such as salaries, are not included.”
To Be Included in Cost of Revenue
Raw Materials – Service based businesses don’t have “raw materials” but if you were a product based business, you would include all raw materials used to produce the product in cost of revenue.
Direct Labor – Direct labor should be included in cost of revenue. Let’s say you own a junk removal business, and you get a job to clean up an old building. It will be a 3 hour job for your team of 3 guys. Each guy is paid $10 per hour. Your employees wages is considered cost of revenue, so in this scenario you would have $90 in direct labor costs that would be included in your cost of revenue.
Shipping Costs – Let’s say you own an accounting firm that audits companies. At the end of the audit you print your report and mail copies to each member of the client’s board of directors. If you end up paying $100 to ship your report to the board, that $100 should be included in cost of revenue because it is a necessary expense that you incur as part of your service.
Sales Commissions - Sales commissions are another common expense that should be included in cost of revenue. You only incur sales commission expenses when you generate revenue through a sale of your product or service; therefore, sales commissions should be included in your cost of revenue.
A common rule of thumb when determining what is cost of revenue and what is not, is to simply ask yourself, “Would I incur this expense if I did not make a sale today?”
Not to Be Included in Cost of Revenue
Now I will go through a list of expenses that you would incur whether or not you sold a product or service. These expenses should not be included in cost of revenue.
Salaries – Employee salaries are not directly tied to revenue, in other words, your employees are paid the same salary each month whether they sell more or less goods and services.
Rent – Your rent expense is another overhead cost that is not included in cost of revenue.
Phone Service – The phone bill will arrive each month whether you sell 100 widgets or 1,000,000 widgets; therefore, it is not to be considered part of your cost of revenue.
Utilities – Now this might be up for debate because your utilities might go up or down based heavily upon your sales volume, but even if you did not sell any product or service next week wouldn’t you still turn the lights on? Wouldn’t you still heat or call your office building? In general your utilities are not considered as past of Cost of Goods Sold or Cost of Revenue.
Cost of Revenue Per Unit
Once you have determined which expenses to include in cost of revenue, you should come up with your cost of revenue per unit. Cost of Goods Sold per unit and Cost of Revenue per unit is the model we use with our ProjectionHub application.
Essentially you need to breakdown each expense that your cost of revenue is comprised of into a unit cost. For example:
Let’s say you own a tree service company. Let’s go through the cost of revenue for one day-long tree service job. Your cost of revenue might look like this:
Sales Commission – You might have a sales representative who secured the job for you, who you will need to pay a commission. Let’s assume you give a 15% sales commission.
Fuel Costs – You have to drive out to the job site with a fleet of 3 vehicles and equipment. This is an expense that you would only incur if you got the job; therefore, it should be included in cost of revenue. The job site is 50 miles away, so each vehicle will drive a 100 mile round trip. So 300 miles at .50 cents a mile is $150.
Direct Labor – Lastly, you will have direct labor costs. Let’s assume it takes a team of 5 to complete the job in 8 hours. You pay them each $10 per hour.
Now that you have identified your 3 items that make of cost of revenue, you need to bring this down to cost of revenue per unit. The unit that most service businesses use is hours. Let’s say you charge the client $300 per hour. Your cost per hour would look something like this:
5 workers x $10 = $50 per hour
15% of $2,400 job = 360 sales commission / 8 hours = $45 per hour
$150 / 8 hours = $18.75 per hour
Add that together and you get $113.75 per hour as your cost of revenue.
$300 – $113.75 = $186.25 is your gross profit.
There you have it. That is how you calculate both cost of revenue and gross profit for a service based business.