Over the last couple of years, PYA has observed clients in various service industries working to add a cost of sales component to their financial statements in an attempt to measure gross margin. Gross margin is not necessarily well-defined per Generally Accepted Accounting Principles (GAAP) for companies outside of manufacturing and distribution. Significant judgment is required to determine what components should be included in cost of sales.
Cost of sales should represent costs directly related to creating the products an entity sells or the services it provides that generate service revenue.
These costs typically include:
- Direct costs, such as labor.
- Any product costs transferred.
- Certain indirect costs, such as depreciation costs associated with certain service contracts or hosting arrangements necessary to supply services to customers.
Examples of Cost of Sales
The examples below are the expenses within cost of sales from several publicly traded companies in the service industry, including Phreesia, Salesforce, Square, and Bill.com’s annual or quarterly reports.
Phreesia– Software as a Service (SaaS) (Online Check-In for Medical Offices)
Phreesia’s 10-K report explains that its cost of sales contains personnel expenses for implementation and technical support (including salaries and benefits, bonuses, stock-based compensation, and costs to verify insurance eligibility and benefits) and infrastructure costs for operation of its SaaS-based platform (such as hosting and other certain fees paid to various third-party partners for the use of its technology). Notably, Phreesia does not include amortization of capitalized software costs, and this exclusion is disclosed in its report as required. If a company does not include depreciation and amortization in cost of sales, it must denote this on the face of the statement of operations.
Salesforce– Cloud Computing Software
As reported on its 10-Q, Salesforce’s cost of sales is divided into two sections: 1) subscriptions and support; and 2) professional services and other. “Subscriptions and support” consists of expenses related to service delivery and support provision, including the costs of data center capacity and certain fees paid to various third parties for technology usage, services and data, salaries and benefits, and amortization of acquisition-related intangible assets (e.g., the cost associated with an acquired company’s research and development efforts). “Professional services and other” consists of employee-related costs associated with these services, including stock-based expense, the cost of subcontractors, and certain third-party fees.
Square– Point-of-Sale Software
As described in Square’s 10-K report, its cost of sales includes transaction-based costs, subscription and service-based costs, hardware costs, Bitcoin costs, and amortization. Transaction-based costs consist primarily of interchange and assessment fees, processing fees, and bank settlement fees paid to third-party payment processors and financial institutions. Subscription and service-based costs primarily relate to Cash App, including Instant Deposit and Cash Card, as well as Instant Transfer for sellers. Hardware costs consist of all product costs associated with contactless and chip card readers, Square Stand, Square Register, Square Terminal, and third-party peripherals. Product costs also include manufacturing-related overhead and personnel costs, certain royalties, packaging, and fulfillment costs. Bitcoin costs comprise the amounts Square pays to purchase Bitcoin. Lastly, amortization of acquired technology relates to technologies obtained in a transaction.
Bill.com– Automated Payables and Receivables Platform
Bill.com’s 10-K report explains that its cost of sales includes:
- Personnel-related costs, including stock-based compensation expenses for its customer success and payment operations teams.
- Certain costs directly attributed to processing customers’ transactions, such as cost of printing checks, postage for mailing checks, and expenses for processing payments.
- Direct and amortized costs for implementing and integrating Bill.com’s cloud-based platform into its customers’ systems.
- Costs for maintaining, optimizing, and securing Bill.com’s cloud payments infrastructure.
- Amortization of capitalized internal-use developed software.
- Amortization of developed technology.
- Fees on the investment of customer funds.
- Allocation of overhead costs.
Reporting Cost of Sales
Ultimately, the determination of what constitutes cost of sales is up to management, and costs should be carefully considered so as not to mislead the users of financial statements. Costs should also be applied consistently from period to period. Additionally, management should thoroughly evaluate the valuation implications associated with presenting gross margin on its financials, and approach the exercise with transaction due diligence in mind. This approach can be helpful in considering what an outside party may deem cost of sales and may help an entity avoid overly high gross margins.
Furthermore, users of an entity’s financial statements can glean a clearer understanding of the calculation of gross margin from proper documentation and consideration of what labor is captured in cost of sales and what labor is captured elsewhere on the income statement. It is important to remember an entity is not required to present gross margin on service companies’ financials, and presenting a cost of sales number may not provide value for financial statement users.
If you have questions related to cost of sale and gross margin or need additional guidance related to business management and advisory or audit and accounting, contact a PYA executive below at (800) 270-9629.