Updated July 11, 2023
Definition of Cost of Revenue
The term “cost of revenue” (COR) refers to the total cost incurred toward a company’s production and distribution of products and services. In other words, any costs directly attributed to producing and distributing goods and services are captured under the COR.
It is similar to costs of goods sold (COGS) but includes distribution and marketing expenses and other directly attributable expenses.
Explanation of Cost of Revenue
A company’s income statement contains the COR, which captures all the direct costs associated with the goods manufactured or services provided by the company. However, the cost of revenue may vary from one company to another as the costs head included under the COR varies depending on the industry in which the company operates.
The Formula for the Cost of Revenue
The COR formula can represent the summation of direct material, direct labor, distribution, marketing, and other directly attributable costs. Mathematically, it represents as shown below.
How to Calculate Cost of Revenue?
Follow the steps below to calculate the COR:
- Step 1: Firstly, determine the direct cost of material, which includes raw material consumption and a change in inventory towards work-in-process products.
- Step 2: Next, determine the direct labor cost, which includes the cost of manpower engaged in the production.
- Step 3: Next, determine the distribution costs, which include expenses incurred to deliver the product at the customer’s place.
- Step 4: Next, determine the marketing costs, which include advertising and agency fees incurred for promoting the product.
- Step 5: Next, determine all other directly attributable costs not included in the above-mentioned cost heads.
- Step 6: Finally, the formula for COR can be derived by adding direct material (step 1), direct labor (step 2), distribution costs (step 3), marketing costs (step 4), and other directly attributable costs (step 5), as shown below.
Cost of Revenue = Direct Material + Direct Labor + Distribution Costs + Marketing Costs + Other Directly Attributable Costs
Examples
Following are examples given below:
Example #1
Let us take the example of a company to illustrate the concept of COR. The company is engaged in the production of soft drinks in the state of Illinois. The following information is available for the year 2019:
- Direct material = $20 million
- Direct labor = $10 million
- Distribution costs = $2million
- Marketing costs = $4 million
- Other directly attributable costs = $1 million
Determine the COR of the company for the year 2019 based on the given information.
Solution:
COR calculate as:
Cost of Revenue = Direct Material + Direct Labor + Distribution Costs + Marketing Costs + Other Directly Attributable Costs
- COR = $20 million + $10 million + $2 million + $4 million + $1 million
- COR = $37 million
Therefore, the company incurred a cost of revenue of $37 million during the year 2019.
Example #2
Let us use SDF Inc.’s example to demonstrate which expenses should be considered under the COR. The company is a manufacturer of solar lamps and operates in the state of Missouri. Determine the cost of revenue of the company for the year 2019 on the basis of the information provided below:
- Direct material = $50 million
- Salary paid to managers = $9 million
- Direct labor = $20 million
- Research & development expenses = $4 million
- Distribution costs = $5 million
- Administration costs = $10 million
- Marketing costs = $8 million
- Other directly attributable costs = $2 million
Solution:
In this case, salary paid to managers, research & development expenses, and administration costs won’t be considered in the calculation of the COR as these costs are indirect, i.e., can’t be directly attributed to the production process.
Now, the COR for the company can calculate by using the above formula,
The cost of Revenue calculates as
Cost of Revenue = Direct Material + Direct Labor + Distribution Costs + Marketing Costs + Other Directly Attributable Costs
- COR = $50 million + $20 million + $5 million + $8 million + $2 million
- COR = $85 million
Therefore, SDF Inc. incurred a cost of revenue of $85 million during the year 2019.
Importance
From the perspective of cost, the cost of revenue is a very important concept as it reveals the entire input cost of production during a given period of time. It provides a clear breakdown of the direct and indirect costs involved in production, which can be a crucial input for management decision-making. Most companies analyze the cost of revenue and use it to optimize their operations by eliminating the excess costs incurred during the production process.
Benefits
- It can use to strike the optimal mix of direct and indirect production costs.
- It is helpful in the identification of sudden changes in the cost structure.
Disadvantages
- There is some level of subjectivity about the cost heads that goes into calculating the cost of revenue, which impedes standardization.
- The accountants and managers can manipulate the COR for their own vested interests.
Conclusion
So, it can be seen that cost of revenue is a crucial factor in analyzing a company’s cost structure and profitability. However, it should be noted that its components may vary depending on the industry and nature of operations.
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