The topic of this episode is, what goes into the cost of goods sold. This might seem obvious, but that’s not always the case. The topic sort of came from a listener, who was wondering about what might go into the cost of goods sold for a software as a service company. That topic was too narrow for the podcast, but it seems worthwhile to back up for a minute and discuss the criteria for what should go into the cost of goods sold.
Accounting Rules of the Cost of Goods Sold
The accounting rules for the cost of sales and services is described in section 705 of the accounting standards codification, which covers generally accepted accounting principles. The funny thing is – there’s literally nothing in it. Section 705 just refers you out to specialized areas, like agriculture and federal government contractors, for more information.
So, what we have here is a presentation issue for which there really isn’t any guidance – what goes into the cost of goods sold, as stated on the income statement?
Criteria for the Cost of Goods Sold
One possible rule is to include in the cost of goods sold anything that’s a direct cost of sales. This means that a cost is only incurred if a sale occurs. The obvious items here are direct labor and direct materials, which everyone puts in the cost of goods sold. But what about credit card fees, and sales commissions? These expenses only happen if there’s a sale, so shouldn’t they also be presented within the cost of goods sold?
Both items might very well be listed lower down in the income statement, with credit card fees listed within the bank expenses line item for the accounting department. And you might find sales commissions within the sales department’s expenses, as part of compensation.
So, you could include these items in the cost of goods sold, though general practice places them lower down in the income statement. A possible reason for not including them in the cost of goods sold is that jamming them into the cost of goods sold lowers the reported gross margin. If you happen to be a public company, then this could be a problem, because your reported gross margin would then be lower than what everyone else in the industry is reporting.
To muddy the waters even further, consider this scenario. During the pandemic, a lot of tenants couldn’t pay their rent, so they struck deals with their landlords to pay them a portion of their revenues instead of the usual fixed rent payments. Should these payments be included in the cost of goods sold? Variable rent payments are a direct cost of sales – but they have nothing whatever to do with the cost of the goods that are being sold. So, no – variable lease payments are an administrative expense.
So, my possible first rule of what to include in the cost of goods sold doesn’t seem to work that well. Let’s try a second rule, which is to base the decision on the name of the line item in the income statement – the cost of the goods that are sold.
This sounds a bit more traditional. Under this logic, we can include the cost of direct labor, and direct materials, and factory overhead – pretty much what you’d normally see in any income statement. This sounds great – for a manufacturing company, where tangible goods are being sold. Lots of companies don’t do business that way, which makes the situation more difficult.
For example, let’s go back to the original question posed by a listener, which was – what goes into the cost of goods sold for a software as a service company? In this case, subscribers are accessing the provider’s software online in exchange for a monthly subscription fee. What is the cost of goods sold?
Well, the service being provided is the software and database combination that customers use. This certainly means that the computer system hosting cost falls within the cost of goods sold. On top of that, the cost of the people who keep the hosting environment running should be included. Also, if you’re paying royalties for the software being offered to customers, then that would be a cost of goods sold. And for that matter, if the company is helping its customers with implementation – to start using the service – then that could be considered a cost of goods sold.
So as you can see, the presentation decision varies enormously, depending on your industry.
At this point, I’ll offer a third rule for how to clarify the situation, which is rather than assuming that everything belongs within the cost of goods sold, do the reverse and assume that it belongs elsewhere else, and review the pros and cons. It might result in a change in classification.
Fourth rule. Look at accepted industry practice. You can hardly go wrong with the auditors if everyone else is already doing it. And, of course – fifth rule – just ask the auditors. They will probably be quite definitive about the key components of the cost of goods sold, but might leave some gray areas around the edges, where you can either include some expenses, or not.
A final thought is that, whatever you decide to do, stick with it for a long time. If you keep moving items in and out of the cost of goods sold, then it’s too difficult to figure out a trend line of the gross margin percentage. And management needs that number to run the business.