The SEC requires organizations to present a Cost of Sales measure on their Income Statement; if this measure excludes depreciation and amortization, it must be labeled as such throughout a company’s financial statements.
Consequently, companies must thoughtfully analyze the nature of expenses reflected within Cost of Revenues. This exercise calls for a degree of judgment due to minimal guidance specific to this area. This judgment, though, is variable and often requires expert support.
Below is a typical list of considerations and observations we have worked through with our clients on this topic:
Internal Initiatives
Certain internal activities, such as training provided to staff that’s non-essential or coaching in nature, are distinct from other initiatives. That’s the case even for employees who spend the majority of their time and responsibilities on earning revenue.
These activities are more akin to professional development than revenue generation and could be classified as G&A versus Cost of Revenues.
For more mature companies, a timesheet system can allow companies to classify these costs appropriately and provide a deeper understanding of how employees spend their time. However, a timesheet system may not always be practicable. In such instances, an analysis of non-revenue generating activities can be used to determine a reasonable allocation of employee costs between G&A and Cost of Revenues.
This analysis can be revised quarterly to ensure business changes are being captured appropriately.
Facilities
When companies make use of a building, consider the duties performed by the individuals in the physical space. Are their tasks contributing directly to revenue generation or are they mostly administrative?
Typical examples would be a manufacturing facility (revenue generation) versus a corporate office with back-office functions (administrative).
Cost Allocations
Not all costs that relate to revenue generation can be easily identified, and often an allocation methodology will need to be implemented.
Define a policy that aligns with the allocated overhead costs, such as headcount for employee-related expenses or square footage for a mixed-use building. After establishing a defined policy, the company must continually assess the accuracy of the policy, especially when significant business changes occur.
Payroll and GL System
Accounting systems enable the alignment or tagging of employees to specific cost centers and, in turn, general ledger accounts.
Maintaining separate GL accounts and/or cost centers for Cost of Revenues may seem like an arduous process to set up, but the long-term benefits may outweigh the short-term pain.
Separate GL accounts and cost centers allow companies to gain more accurate internal and external profitability reporting, enabling a robust budgeting and forecasting process.
The ability to accurately record and report on Cost of Revenues across all periods may not be a quick process and it often requires input from various operational stakeholders within an organization.
Organizations can achieve meaningful benefits from performing a detailed analysis of Cost of Revenues, empowering a shift in how management measures performance and evaluates business operations. It’s critical to complete such an assessment prior to the preparation of a registration statement or other Regulation S-X compliant financial statements.
For expert reporting and systems support, contact CrossCountry Consulting.