Calculating COGS for a Software Company: Calculating Depreciation (pt. II)

Editor’s Note: This is the fifth 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 straight-line depreciation, one of the most common methods for calculating depreciation. In this post, we will cover another very common method for calculating depreciation – the declining-balance method.

Declining-balance Method

The declining-balance method is an accelerated depreciation calculation method that provides for a higher depreciation charge in the first year of an asset’s life and gradually decreases charges in subsequent years. This may be a more realistic reflection of the actual expected benefit from the use of the asset: many assets are most useful when they are new.

annual depreciation = depreciation rate * book value at beginning of year

The most common rate used in the declining-balance method is double the straight-line rate. For this reason, this technique is referred to as the double-declining-balance method. For example, suppose Initrode, LLC buys a server that costs $1,000, has a four-year useful life, and no salvage value. First, calculate the straight-line depreciation rate. Since the asset has four years of useful life, the straight-line depreciation rate equals 25% per year (100% / 4 years).

With the double-declining-balance method, as the name suggests, double that depreciation rate, or 50%, is used. In the beginning of year one, the book value of the server is $1,000, and the depreciation expense in year one is $500 ($1,000 * 0.5). In the beginning of year two, the book value of the server is $500, and the depreciation expense in year two is $250 ($500 * 0.5). In the beginning of year three, the book value of the server is $250, and the depreciation expense in year three is $125 ($250 * 0.5). In the beginning of year four, the book value of the server is $125, and since this is the last year of the server’s useful life and the salvage cost is $0, the depreciation expense in year four is $125 – $0 = $125.

Ready for more? Read the sixth post here.