Cost of Revenue

Cost of Revenue (often used interchangeably with its close cousin, Cost of Goods Sold or COGS) is the total of all the direct costs a company incurs to create and deliver a product or service to its customers. Think of a local artisan bakery. The Cost of Revenue would include the price of flour, sugar, and eggs; the wages of the bakers who mix the dough and run the ovens; and the cost of the electricity used to power those ovens. These expenses are directly tied to the creation of the delicious pastries sold. Costs that are not directly tied, like the salary of the marketing manager, the rent for the corporate office, or advertising expenses, are excluded. This crucial figure is found near the top of a company's Income Statement, right below Revenue. Understanding it is the first step in dissecting a company's true profitability and operational efficiency.

While the core idea is simple—what did it cost to make the thing you sold?—the specifics can vary depending on the type of business. This is where the distinction between “Cost of Revenue” and “Cost of Goods Sold” becomes clearer.

Traditionally, COGS is the term used for businesses that make and sell tangible items. The costs are straightforward:

• Raw Materials: The cost of all the basic ingredients or parts used to make the product. For a car company, this is steel, glass, and rubber. For our bakery, it's flour and yeast.
• Direct Labor: The wages and benefits paid to the employees who physically touch the product during its creation. This includes assembly line workers and, in our example, the bakers.
• Manufacturing Overhead: Indirect costs that are still essential for production. This could be factory rent, utilities for the production facility, and depreciation of manufacturing equipment.

“Cost of Revenue” is a broader term that has become popular with companies that don't sell physical goods, such as software-as-a-service (SaaS) or consulting firms. Their direct costs look different:

• Hosting and Infrastructure: For a software company like Netflix, this includes the massive server costs required to stream content to millions of users.
• Customer Support: Salaries for the support team that helps users with the product or service.
• Third-Party Fees: Royalties or data fees paid to other companies that are essential for delivering the service. For Spotify, this would be the licensing fees paid to music labels.

For a Value Investing practitioner, the Cost of Revenue is far more than just a number; it's a vital clue to a company's health and competitive standing.

By subtracting the Cost of Revenue from a company's total Revenue, you get a critical metric: Gross Profit.

• Gross Profit = Revenue - Cost of Revenue

This tells you how much money the company makes from its core business operations before accounting for other expenses like marketing, R&D, and taxes. Taking this a step further, we can calculate the Gross Margin.

• Gross Margin (%) = (Gross Profit / Revenue) x 100

A high and stable (or rising) Gross Margin is often a hallmark of a fantastic business. It suggests the company has strong pricing power, efficient production, or a unique product that customers are willing to pay a premium for. This can be a strong indicator of a Competitive Moat.

A savvy investor doesn't just look at one year's number. They track the Cost of Revenue as a percentage of sales over several years.

• A rising trend can be a red flag. Is the company losing its ability to control costs? Is it facing so much competition that it can't pass on rising material costs to its customers? This can signal an eroding competitive advantage.
• A falling trend is a beautiful sight. It often means the company is becoming more efficient, benefiting from economies of scale, or gaining more power over its suppliers.

How does your target company's Gross Margin stack up against its closest rivals? A company that consistently boasts a higher Gross Margin than its competitors likely has a significant, durable advantage. It might have a better brand, superior technology, or a more efficient cost structure. This is precisely the kind of high-quality business value investors seek.

The Cost of Revenue is the foundation of profitability analysis. It's the first major expense that gets subtracted from a company's sales, and its size and trend reveal a great deal about the business's operational guts and its position in the market. Before you even look at a company's net profit or P/E ratio, start here. A deep understanding of what drives a company's Cost of Revenue will give you a powerful lens through which to view its long-term investment potential.