Direct Answer
Cost of revenue -- also called cost of goods sold (COGS) -- is the direct costs attributable to producing the goods or services a company sells. For a product company that typically includes raw materials, direct labor, and manufacturing overhead; for a service company it may include direct labor and delivery costs. It's subtracted from revenue to calculate gross profit, and it's reported near the top of the income statement, directly below revenue.
Key Takeaways
- Cost of revenue represents the direct costs of producing what a company sells -- it excludes indirect costs like marketing, R&D, and general administration.
- Product companies typically include raw materials, direct labor, and manufacturing overhead; service companies may include direct labor and delivery costs instead.
- Revenue minus cost of revenue equals gross profit, one of the first subtotals on the income statement.
- What counts as "direct" can vary by company and industry, so cost-of-revenue comparisons are typically most meaningful within the same sector.
What Is Cost of Revenue?
Cost of revenue is the accounting line item that captures the direct costs a company incurs to produce the goods or services it sells during a period. It sits at the top of the income statement, right below revenue, and it's the first cost a reader encounters when working through a company's profitability.
The composition of cost of revenue commonly differs by business type. A manufacturer's cost of revenue typically includes the raw materials that go into a physical product, the direct labor of workers who build it, and manufacturing overhead such as factory utilities or equipment depreciation tied to production. A service business, which doesn't produce a physical good, may instead report direct labor -- the people delivering the service -- along with delivery costs associated with getting that service to the customer.
What cost of revenue does not capture is just as important: costs that support the business broadly rather than the specific act of producing what's sold -- selling and marketing expenses, general and administrative overhead, and research and development -- are reported separately, further down the income statement, as operating expenses.
How Cost of Revenue Fits Into the Income Statement
Cost of revenue is reported near the top of the income statement, directly below revenue. Subtracting it from revenue produces gross profit, the first major profitability subtotal a company reports:
Gross Profit = Revenue − Cost of Revenue
From there, operating expenses (such as selling, general and administrative expenses, and research and development) are subtracted from gross profit to arrive at operating income, and further items -- interest, taxes, and other non-operating items -- are subtracted to arrive at net income. Cost of revenue is the first of several cost layers between the top-line revenue figure and the bottom-line profit figure.
| Income statement line | Role |
|---|---|
| Revenue (net sales) | Total sales generated during the period |
| Cost of revenue (COGS) | Direct costs of producing what was sold |
| Gross profit | Revenue minus cost of revenue |
| Operating expenses | Selling, general/administrative, R&D, and similar costs |
| Operating income | Gross profit minus operating expenses |
Worked Example
Hypothetical example -- for education only.
Suppose a company sells $10,000,000 of product in a quarter. Its production costs for that period break down as follows:
- Raw materials: $3,200,000
- Direct labor: $1,800,000
- Manufacturing overhead: $1,000,000
Cost of revenue = $3,200,000 + $1,800,000 + $1,000,000 = $6,000,000.
Gross profit = $10,000,000 − $6,000,000 = $4,000,000, which corresponds to a gross margin of $4,000,000 ÷ $10,000,000 = 40%.
That $4,000,000 gross profit is what remains to cover operating expenses like marketing, administration, and R&D before arriving at operating income -- the direct production costs have already been accounted for at this stage.
Why Cost of Revenue Matters
Cost of revenue is the input to gross profit and gross margin, two figures commonly used to gauge how efficiently a company converts sales into profit before accounting for the rest of its operating costs. A rising cost of revenue relative to sales can signal pressure from input prices, wage costs, or production inefficiency, while a shrinking cost of revenue relative to sales can reflect improved efficiency, pricing power, or a shift in product mix.
Because the specific costs a company classifies as "direct" -- and therefore includes in cost of revenue -- can vary by company and industry, cost-of-revenue and gross-margin comparisons are typically most meaningful when made between companies in the same sector using consistent definitions, rather than across unrelated industries.
Limitations and Common Mistakes
- Classification can vary. Companies have some discretion in how they draw the line between "direct" production costs and broader operating expenses, so cost of revenue is not always calculated identically across companies, even within the same industry.
- Product vs. service composition differs. Assuming a service company's cost of revenue looks like a manufacturer's (heavy on raw materials) can misread what's actually driving the number.
- It's not the full cost picture. Cost of revenue excludes operating expenses like marketing, admin, and R&D -- a low cost of revenue alone doesn't mean a company is profitable overall.
- Cross-industry comparisons can mislead. Gross margins differ structurally across industries (for example, software versus heavy manufacturing), so comparing cost of revenue or gross margin across unrelated sectors is typically less informative than comparing within a sector.
Frequently Asked Questions
Is cost of revenue the same as cost of goods sold (COGS)?
The terms are commonly used interchangeably. "Cost of goods sold" traditionally describes the direct production costs of a physical product, while "cost of revenue" is the broader label many companies -- especially service and software businesses -- use for the same line item on the income statement, since their direct costs may not involve physical goods at all.
What is included in cost of revenue?
For a product company, cost of revenue typically includes raw materials, direct labor, and manufacturing overhead. For a service company, it may include direct labor and delivery costs. The exact mix can vary by company and industry, and businesses have some discretion in how they classify costs between cost of revenue and operating expenses.
How is cost of revenue different from operating expenses?
Cost of revenue captures costs directly tied to producing what a company sells, while operating expenses cover costs of running the broader business, such as sales, marketing, general and administrative costs, and research and development. Cost of revenue is subtracted from revenue to get gross profit; operating expenses are subtracted after that to get operating income.
Where do I find cost of revenue on the income statement?
Cost of revenue is reported near the top of the income statement, directly below revenue (also called net sales or total revenue). It is typically the first cost line item a reader encounters, immediately before the gross profit subtotal.
Why does cost of revenue matter to investors?
Cost of revenue is the starting point for gross profit and gross margin, which are commonly used to gauge how efficiently a company converts sales into profit before accounting for operating costs. Because classification practices can vary between companies, comparisons are typically most meaningful within the same industry.
Why do companies classify similar costs differently between cost of revenue and operating expenses?
There is latitude in whether costs such as distribution, customer support, or certain overheads sit above or below the gross profit line, and companies disclose their policy. A company placing support costs in operating expenses reports a higher gross margin than one including them in cost of revenue. This makes gross margin comparisons across companies unreliable without checking the policies.
How does depreciation on production assets appear in this line?
Depreciation of manufacturing equipment is generally included in cost of revenue rather than shown separately, which means gross profit is stated after a non-cash charge. Companies sometimes disclose the amount included. This matters when comparing a capital-intensive producer against one that outsources production, since the latter's equivalent cost appears as a purchase.
What causes cost of revenue to move independently of volume?
Input price changes, shifts in product mix toward items with different cost structures, inventory write-downs flowing through the line, and changes in production efficiency all move the figure without a corresponding volume change. Separating them requires volume data, which some companies disclose. Attributing a cost change entirely to volume is a common oversimplification.
How is cost of revenue defined for a business selling services rather than goods?
It typically comprises the direct costs of delivering the service, most often personnel time and any associated infrastructure, and companies vary considerably in what they include. Because there is no physical product, the boundary between delivery cost and operating overhead is more judgmental than for a manufacturer. The accounting policies footnote states where the company drew it.
References
- SEC EDGAR -- full-text company filings, including annual and quarterly reports where cost of revenue is disclosed.
- SEC: Beginners' Guide to Financial Statements -- guidance on locating and interpreting income statement line items in company filings.
- FASB Accounting Standards Codification -- authoritative U.S. GAAP guidance; inventory costing that feeds into cost of revenue is addressed under ASC 330 (Inventory).