Finance & Operations

Calculating COGS for a Software Company: Professional Service Costs

October 1, 2010

Editor’s Note: This is the seventh and final 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 can 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.

Many software companies offer their customers professional services – typically customization of the software, implementation, or training. Whether or not a company charges additionally for customization, professional services costs belong in COGS. The following is a very brief overview of professional services lines items that are common for software companies.

  • Professional services salaries and benefits: This line item captures the salaries and benefits of a company’s professional services employees that are directly related to delivering the services for which revenue has been recognized during the period. In some cases, professional services staff may be working on non-billable activities such as product development, sales and marketing, etc. These costs should be tracked or estimated and allocated out of COGS at the end of each accounting period and charged to the appropriate functional cost center (sales and marketing, R&D, or G&A).
  • Depreciation of equipment related to providing professional services: All of the equipment related to providing professional services a company buys must be depreciated and added into this line item (this includes, but is not limited to, desks, chairs, computers, phones, headsets, and so forth that are bought for professional services employees). A few common methods for calculating depreciation have already been covered earlier in this series.
  • Leases of equipment related to providing professional services: All of the equipment related to providing professional services that a company leases will have a periodic lease expense that should be added to this line item.
  • Amortization of software related to providing professional services: Most companies will provide their professional services employees with software to facilitate the provision of professional services to customers. For the software that a company subscribes to, the periodic expense is simple to calculate — if the company pays $1,000 per month for software, the quarterly expense is $3,000, the annual expense is $12,000, etc. If the company buys a perpetual license to the software, the company needs to estimate the useful life of the software (typically between 12 – 60 months) and amortize accordingly.
  • Allocated overhead: Since a company’s professional services employees typically sit in an office, the company needs to allocate overhead (such as rent, utilities, travel costs, etc.) for those employees.

Now that we’ve covered the four COGS categories for software companies (material costs, subscription and hosting costs, support costs, and professional services costs), we can calculated a software company’s COGS by totaling the line items in each of the categories and summing the totals. And by subtracting the COGS for the company’s revenue, we arrive at the gross profit, which we can then divide by revenue to get to gross margin.

Further, since most software companies that charge for support and professional services break out their revenues into software/subscription revenues, support revenues, and professional service revenues, we can now also calculate the gross profit and gross margin for all of a company’s revenue-generating lines of business. For example, to calculate the gross profit of a company’s software/subscription line of business, take a company’s software/subscription revenues and subtract material costs and subscription and hosting costs.

If a company can track its revenue and associated costs of goods sold by specific product line or geography, then the company can also calculate gross margin at the product or geographic level. This will allow a company to optimize sales and marketing spend, and invest more in more profitable geographies and lines of business.


Vlad is a CEO at <a href="">Scandent</a>, which develops radio frequency identification (RFID) systems that prevent theft, loss, and wandering/elopement in hospitals and nursing facilities. Previously, he was an Associate at OpenView.