The cost of revenue is often confused with the cost of goods sold. They are thought to be the same since they both calculate the costs incurred in making a sale. However, the truth is that the two are not the same. The cost of goods sold does not include all the costs that were incurred to bring the products into a saleable condition.
The cost of revenue, on the other hand, is more general and includes the cost of goods sold as well as a range of other costs to make a sale possible. It is, after all, the cost of sales.
The cost of revenue includes the costs you incurred while marketing and selling your products and services.
The Cost of Materials
In this case, we’re talking about the direct materials that have been built into the product. The concept of direct materials is quite useful in the area of cost accounting, where the cost of materials is categorized into different types of costs so that it can more easily lend itself to financial analysis.
The direct materials are considered part of the total cost of goods produced and is plugged into the cost of goods sold formula. The cost of goods produced is then divided into two types of costs: the cost of goods sold and the closing inventory. The cost of goods sold goes into the income statement while the closing inventory goes on the statement of financial position, also known as the balance sheet.
The category of direct materials often includes all the materials that are present in the finished goods. These include raw materials and any sub-assemblies that are involved. It further includes any spoilage or scrap generated during the production process. These may not be part of the final product, but they are still a direct cost of production.
Anything that is used up in production but doesn’t appear in the final good, also known as a consumable, isn’t considered part of the direct materials. For example, the machines producing the goods will need machine oil to function smoothly. The machine oil, however, will not end up in the final product and will therefore not be considered a direct material. Another thing to remember about consumables is that, while they are variable costs, changing with the volume of production, they cannot be traced back to any unit of production.
A useful concept to consider when dealing with direct materials is the material yield variance, which is calculated using the amount of direct material used in production. Another useful figure is the purchase price variance, which is the difference between the expected cost of the direct materials and their actual cost.
The cost of the direct materials will also be used to calculate the contribution margin.
In an organization that sells a service, rather than a product, there is no concept of direct materials. The main cost to sell services is labor.
The Cost of Labor
In this case, we’re talking about direct labor, which is the labor that is directly associated with a specific product, a specific work order or a specific cost center. Take the case of a manufacturing business, for example, where direct labor is the labor that is provided by the production crew in charge of producing the goods. These include painters, operators on the assembly lines, machine operators and so on.
For a service business, it’s only slightly different since direct labor is the labor of those employees who directly serve customers, such as waiters, lawyers and consultants. Anyone who is charging time to a customer is an example of direct labor.
The cost of direct labor consists of a few elements, including the regular hours that were worked, any shift differentials, overtime hours and also payroll taxes. If you go deeper, you can even expand the concept to include fully burdened direct labor, which also includes the benefit costs earned by the direct labor employees.
Direct labor is part of the direct costs of a business, which means that it will vary with the revenue of the business or the production volume of the business. This may not always be the case, however, when you’re dealing with a manufacturing firm. In a manufacturing firm, a certain level of staffing is always required, whatever the production volume is. The concept of direct labor costs lends itself a lot more easily in an environment that works through professional billing. In such cases, direct labor will vary with revenue changes.
The Cost of Sales Discounts
A sales discount is any reduction in the advertised purchase price of a product or service that the seller gives a buyer for any number of reasons. Sellers often use this tactic when they have an immediate need for cash.
A good example of a sales discount is the 5/10 net 30 terms. This is business parlance meaning: The customer will get a five percent discount if they pay an invoice within 10 days of the date on the invoice. Alternatively, if they don't take advantage of the pay-within-10-day discount, they pay full price for the product if they pay within 30 days after the date on the invoice.
According to Accounting Tools, the concept of sales discounts also applies in the case of cash sales, where the customer can get a discount for paying immediately. Something to note here is that sometimes the interest rate that is incurred with a sales discount can be rather hefty, which is why some organizations do not offer sales discounts to their customers.
Sales Commissions and Fees
A commission is a fee paid to a member of the sales team for making a sale. It may be a flat commission, or it may be offered as a percentage of the profit, gross margin or revenue.
Other costs included in the cost of revenue are the cost of labor to sell a service and the cost of making sales calls.
It should be noted that any indirect costs of selling and marketing such as advertising costs, marketing brochures or trade shows are not included in the cost of revenue. The cost of revenue only involves direct costs that can be traced back to an individual unit.
Calculate the Cost of Revenue
- To calculate the cost of revenue, pick the period for the calculation, which is generally a quarter or a year.
- Find out what the beginning inventory was for the period, the cost of goods produced and sold during the period and the closing inventory for the period. Include all the costs associated with production and sales.
- Take the beginning inventory, add the cost of production, then subtract the ending inventory for the period. The result is the cost of revenue for the period.
In a service industry, it is a little more straightforward since there isn’t a cost of goods produced and sometimes no inventory either. Simply take the direct costs associated with making sales, and you have your cost of revenue.
- Using the cost of revenue, along with the product’s offered price, determine the profit margins for the product. Compare it to profit obtainable in the production of other goods to choose whether you can put the resources involved to a more profitable use.
Nicky is a business writer with nearly two decades of hands-on and publishing experience. She's been published in several business publications, including The Employment Times and Business Idea Factory. She also studied business in college.