Cost of Goods Sold (COGS), sometimes called Cost of Revenue, is the total expense your company must pay in order for your customers to receive their paid goods or services. Traditionally, these are the costs to deliver the service paid for, but not develop the service or operate the company.
Imagine subscribing to a software system that provides payroll services. You need to be able to log into the system to run payroll in order to receive the service you’ve paid for. Therefore, the cost of that company’s hosting provider for their production environment is a Cost of Goods Sold.
On the other hand, if they run out of printer paper in their offices, this wouldn’t affect your payroll experience, making office printer paper not classified as COGS. Similarly, if their design team is brainstorming a new direct deposit feature but decides not to build it, there is no impact to the service that you have already paid for, so design software doesn’t factor into COGS either.
Why is it important to report COGS and operating expenses separately?
COGS has a much greater impact on the value of a business than standard operating expenses. The difference between Revenue and COGS is called Gross Profit. Gross Profit is the greatest Income the company can make for their Revenue, assuming all operating expenses were cut from the business. A company with a high Gross Profit relative to Revenue is a High Margin company, worth quite a bit by a potential acquirer or on the public market.
When a company is evaluated for an acquisition or IPO, an independent auditor will perform a valuation, analyzing many key metrics, including Revenue, Net Income/Profit, Gross Profit and Gross Margin percentage. If COGS and operating expenses are not properly allocated, the company may need to restate their financials at great time and expense to the company, which could look something like a team of auditors from a Big 4 accounting firm taking up residence in your offices for six months. We recommend avoiding this at all costs.
What is a good COGS amount?
A target amount of COGS spend depends on your company’s Revenue. The higher your Revenue, the more your company will spend on Cost of Goods Sold.
A good rule of thumb is a SaaS business should have about an 80% Gross Margin, though the majority of publicly-traded SaaS businesses have lower margins than this. Use this table to target an ideal COGS spend based on the 80% ideal margin and your company’s revenue.
What about bills that include both COGS and non-COGS charges?
Many of the expenses that are classified as COGS are billed together with operating expenses. A classic example is a cloud hosting bill. Even though all the expenses may be billed to you by AWS, some of these expenses are for the production environment, some are for development and/or testing, and others may be for marketing, IT Support, or other departments.
Because the vendor doesn’t know what purpose you use their services for, it’s your company’s responsibility to properly separate out a single bill and record the expenses separately in the accounting system. Often, it’s the job of the CTO to split out or itemize portions of the AWS bill on their credit card statement by COGS, operating expenses, or other expense categories. While many companies use a percentage method of the overall bill to roughly allocate a portion of the spend to COGS, exact amounts are always preferred.
In the case of the AWS example, it can be helpful to separate production resources into a separate member account in your AWS organization, making allocations easier.