Calculating COGS for a Software Company: Calculating Depreciation
September 9, 2010
Editor’s Note: This is the fourth post in a series that combines 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.
In the last post of this series, we covered the line items that comprise the subscription and hosting costs category within COGS. One of the line items in subscription and hosting costs was depreciation of data center equipment, and in this post, we will cover a common method for calculating depreciation – the straight-line method.
Straight-Line Method
Straight-line depreciation is the simplest and most-often-used technique to calculate depreciation, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life) and will expense a portion of the original cost in equal increments over that period. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of.
For example, if a server that costs $1,000 depreciates over four years and has a salvage value of $0, it will depreciate at a rate of $250 per year. To calculate the monthly depreciation rate, simply replace “annual” with “monthly” and “years” with “months” in the formula above.
In the next post, we will cover another commonly used method to calculate depreciation – the declining-balance method.
Ready for more? Read the fifth post here.