Calculating COGS for a Software Company: Material Costs

Editor’s Note: This post is the second 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 this post, I will cover the first of four COGS categories I outlined in my previous post: material costs. Many software companies have little or no material costs. For example, software as a service companies deploy their software over the web and do not send their customers any hardware or physical goods (and therefore, have no material costs). There is, though, a couple of different types of software companies that will include material costs in their COGS calculation.

If a software company sells perpetual licenses of the software it ships to its customers in a package that includes CDs and an instruction manual, its material costs, while minimal, will be:

• Cost of the CDs and non-electronic documentation
• Cost of product packaging (including labor costs)
• Cost of shipping and any other fulfillment costs

If, for example, the company sells 50 licenses of its software in a certain period, its material costs for that period will simply be the cost of 50 CDs and manuals, the cost to package and ship those items, along with any labor costs involved.

Another type of software company that will have material costs is one that sells its customers appliances or servers with its software pre-installed. Typically, companies that sell their software on a hardware appliance will have inventory — assets that are intended for sales that the company keeps on hand. When a company has inventory (for example, a warehouse full of appliances), there are three different ways that a company can use to calculate the raw material and production costs line item: the FIFO method, the LIFO method, and the Average Cost method. Investopedia describes how each of these methods account for inventory.

Ready for more? Read the third post here.