Calculating COGS for a Software Company: Introduction
This blog post is the first in a series of posts that will combine to compose a best practices process on calculating the Cost of Goods or Services Sold (COGS or COS) for a software company. While this series is not meant to be an authoritative guide to all GAAP principles that should be followed when accounting for COGS, it will help a company figure out its COGS and gross profit by product line, geography, etc. This will be especially helpful to companies looking to raise expansion capital, as many venture capital firms ask for this type of information during due diligence. Ideally, it will also allow expansion stage software companies to optimize their sales and marketing spend by investing more resources into more profitable geographies and lines of business.
The Cost of Goods or Services Sold is defined as the direct costs attributable to the production of goods or services sold by a company. COGS includes the cost of materials used in creating a good or service, along with the direct labor costs used to produce it. It excludes indirect costs such as sales and distribution costs. COGS appears on a company’s income statement and can be subtracted from revenue to calculate a company’s gross profit.
For the vast majority of software companies, COGS line items will fall into one of the following four categories: material costs, subscription and hosting costs, support costs, and professional service costs. In this series, we will discuss each of these categories in detail, the line items that compose them, and how to attribute their costs to the appropriate time period.