How to calculate the cost of revenue: Startup cheat-sheet

Cost of revenue – also known as cost of goods sold (COGS) is a vital expense and a key component of your P&L statement that helps you and investors size up the profitability of your products.

With that said, if you are new to accounting and building financial models, putting together COGS calculations can be a daunting task. There’s plenty of confusion – especially for SaaSs – about what exactly goes into COGS, which can lead to faulty calculations that give you and investors the wrong idea about your profitability metrics.

Whether you’re crafting a financial forecast to impress investors or sweating over your tax declaration, chances are you’ll find this article helpful. We’ll lay out what elements must be in your COGS depending on your business model and then discuss how to calculate it.

Why is calculating the cost of revenue so important?

An accurate COGS shows how profitable your product is at a given moment, helps make better pricing decisions, and allows for efficient cost management. It’s a given that COGS should be less than revenue; in fact, the less, the better, as it means you’re making more money that you can put back into the business. 

Here is a simple example. Companies A and B both sell a similar product for $1,000 (revenue), but A’s COGS is $100, while B’s COGS is $500. That means that A can make ten products per one sold (1,000/100) or spend the $900 on customer acquisition and other growth initiatives. In the meantime, B can only make two products per one sold (1,000/500) and has only $500 to reinvest in growth.

In finance, the money you’re left with after deducting COGS from revenue is your gross profit margin:

Don’t look at this metric in a vacuum. Check with industry benchmarks to adjust your expectations and be realistic. No investor will give you money without checking to see if your gross margin is on par with the industry benchmarks and competition. 

But let’s get back to COGS and what you need to know before calculating it.

4 things to keep in mind before calculating the cost of revenue

These ground rules will help you make more accurate calculations and deliver your figures in a way that meets investors’ expectations.

• Know your sales volume. The more products you sell or the more users you have, the more your COGS will be. Producing 1,000 items takes fewer materials than producing 10,000; the same goes for SaaS: every new 1k, 5k, or 10k users require more bandwidth, servers, development needs, etc. Check your current sales volume to understand where you stand.
• Include industry benchmarks. Metrics only work when you put them into perspective. Your COGS and gross profit margin might look good, but that perception could change when you compare it to the industry benchmark and vice versa. Make no mistake, investors will ask about this. 
• Use historical data (if you can). If you have a bit of traction under your belt, use this data to make future forecasts. Investors like reliable figures that are based on reality; these make your forecast more credible and show that you have some skin in the game. Don’t have any traction yet? Not a problem. No one will expect historical data then, so just fill it with benchmarks.
• Keep it simple. Investors have neither the time nor the desire to untangle complex models, so include only what’s necessary. Throwing in more details doesn’t make it more persuasive – just heavier. Just make sure you don’t leave out key data for the sake of simplicity. For example, if there are many significantly different geographies that affect your revenue, go ahead and add the details to your costs.

With that in mind, let’s get to what exactly goes into COGS and the formulas for calculating it.

What are the elements of COGS and how do you calculate them?

What goes in COGS will differ for SaaS and conventional businesses, as well as how you calculate them. But the principle stays the same: include only the expenses directly related to your product revenue. 

Let’s see how to do both.

Elements of COGS for SaaS startups

• Servers and hosting

Hosting and cloud servers for users compose a large chunk of expenses, with their costs being proportionate to the number of users. 

Let’s see how you can approach the calculations.

You have 10,000 users, each using 150MB of data per month, and the price per 1GB of storage is $0.1, Let’s calculate how much a month will cost you:

10,000 users * 150 MB = 1,500,000 MB / 1,500 GB * $0.1 = $150 

Cloud hosting providers also charge a flat fee for providing you services, so add that, too. Let’s say this fee is $500, then $150 + $500 = $650 in COGS for servers and hosting services.

• Payment processing fees

Every time users pay you for their subscription, your payment provider charges a small processing fee. For businesses with a large volume of transactions, these fees can amount to a lofty monthly sum for which they must account. For example, a trivial 3% processing fee grows into a formidable $30,000 for a business with a $1M turnover. Becomes clear why many startups create their own payment processing once they’ve scaled, huh?

Anyway, to forecast it, you need to know two things:

1. Processing fee
2. How much money users paid you in total

Let’s assume you have 1,000 users who pay you $10 per subscription, and the processing fee is 3%:

1,000 users * $10 / subscription = $10,000 

3% from $10,000 = $300 – the sum that goes into COGS.

• Customer Support/Customer Success (CS/CS)

Customer support and customer success teams usually compose the second-largest chunk of COGS for SaaS businesses, especially in a B2B segment. 

To calculate this, you need to find out the average number of CS/CS agents per one customer and their salary in the region. Note that the average number of CS agents per one customer will change during the period of your forecast as your agents become more experienced and effective.

Once found, the number of CS/CS agents is calculated as:

This way:

• API and other third-party solutions

Most startups resort to third-party solutions to deliver services their users need instead of building them from scratch.

Say you are a freshly hatched fintech startup that needs to verify your customers to ensure security. You find a KYC verification provider with each KYC check costing you $1. If you will be attracting 100 new customers a month, it makes $100 of KYC expenses, which go directly to COGS.

• Partnerships/revenue share

Partnerships can be an effective way to attract new clients. They usually work on a revenue share scheme, getting a % from referral revenue. 

For example, you have an application on the Google Play or App Store platform. Then, you will give back about 30% of the revenue from each purchase made through these platforms.

In some cases, the salaries of your product developers can also be included in COGS. It happens if they are directly involved in the production, delivery, or maintenance of the software.

Elements of COGS for traditional startups

• Raw materials

To forecast these expenses, take the price for the material you need to produce one unit of product, and multiply it by the number of products.

For example, you are a solar panel producer and expect to sell 50 panels in the first month. One solar panel production requires raw materials of $1,000. This way:

50 panels * $1,000 = $50,000 in COGS for the first month.

• Personnel cost for manufacturing

This section includes salaries, benefits, and other overhead expenses related to the manufacturing process and labor.

Let’s say a worker needs 10 hours to produce and assemble one scooter. He works 40 hours per week and has a weekly salary of $1,200. Therefore:

$1,200 / 40 h * 10 = $300 in labor COGS to produce one scooter.

Don’t forget to adjust all your COGS to your growth projections; otherwise, your financial forecasts won’t be credible to investors.

Wrapping up: don’t miss out on the benefits of finding your COGS

Calculating COGS can be a headache, as there is no clear-cut list of things to include. There are many factors to consider depending on your business model, industry, number of users, and so on. But, when you understand the main categories of COGS that apply to your business model, it becomes much easier to pin down specific expenses that fall under these categories.

The easiest way to verify your COGS calculations is to look at your gross profit margin. If it’s way below or above industry benchmarks, it’s time to give your numbers a more thorough look. But, once you establish a proper structure and calculation logic for your COGS, it will become your legal cheat sheet for giving investors clear and confident answers about your profitability and boosting your chances of closing that sweet round.

For more tips on creating financial forecasts that investors will love, check out our ample resources on financial modeling.