4. COGS and Operating Expense Projections


In this lesson, we project TrackerTime’s operating costs, examining in detail the reasoning behind our future assumptions of R&D expenses and other such costs.

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  1. Lesson Goal (00:04)

    The goal of this lesson is to create projections for the Cost of Goods Sold and operating expenses.

  2. Projecting the Cost of Goods Sold (00:14)

    Software companies often have a low Cost of Goods Sold, because it costs little money to deliver a software product. As a result, these companies may have gross margins of 80% or higher. In our model, we project the Cost of Goods Sold as a percentage of revenue. We calculate the historical values of this percentage to inform our future projections for the percentage. The percentage drops each year, probably due to economies of scale, and we project continued declines for the coming years.

  3. Projecting Research and Development Costs (01:20)

    In their early days startups have little revenue, and want to develop their product as quickly as possible. As a result, they often have high research and development costs. In our model, research and development costs are projected as a percentage of revenue. We see that this percentage is very high, but it has declined over time due to the large increases in revenue. We project small declines in this percentage over the coming years.

    Although R&D may decline as a percentage of revenue, the actual R&D expense grows over time. This is because revenue grows faster than R&D. We can project revenue, and then R&D, in our Income Statement to verify this trend.

  4. Projecting General and Administrative Costs (03:46)

    General and administrative costs are projected as a percentage of revenue. These costs tend to grow as a business expands, due to the growth in management and support staff. In our model, these costs have dropped as a percentage of revenue historically, but we project they will stay constant as a percentage of revenue in the coming years. Once we project this percentage, we can create a projection for the amount of this expense in the Income Statement.


In the previous lesson, we calculated our revenue projections for Tracker Time. Now, let's calculate our expenses, beginning with cost of goods sold. As Tracker Time is a software product, the cost of goods sold is almost always going to be very low. To deliver a software product, costs very little money. So the gross margins on software products can often be as high as 90 percent. Let's see what the historical gross margins have been for Tracker Time.

By going to the income statement, and dividing cost of goods sold by revenue.

And I'll copy across for the remaining cells.

As we can see, cost of goods sold is quite low to begin with, but drops over time.

This is most likely due to economies of scale that the company has achieved, and it's hosting and support costs as more customers use the platform. I'm going to assume that this margin continues to drop in 2017 to 10.1 percent, then 9.8 percent, 9.5 percent, 9.2 percent, and then stabilizing at this figure.

While the cost of goods sold is normally quite low for a software startup, research and development, and sales and marketing costs tend to be very high, particularly in the early days, when the company is developing the product and has relatively few customers and little revenue. Off camera, I've calculated the historic figures for Oren D as a percentage of revenue. And I've also done this for the general and administrative costs. Let's begin with research and development.

As expected, in the early years, Oren D makes up a huge percentage of revenue, because the company has very little revenue while it's first developing the product. As revenue grows, the research and development budget will also grow, but not nearly at the same rate. After speaking with the CEO of Tracker Time, she wants to keep the Oren D budget fixed at 35 percent in 2017, however she acknowledges that even if she grows the Oren D budget, it probably won't keep up with the current revenue projections. So we'll drop the Oren D cost as a percentage of revenue by one percent each year.

This still means that my research and development budget will grow rapidly. Let's find out how rapidly by going to our income statement, and first projecting our revenue.

And then projecting our research and development, which will equal to revenue, multiplied by the Oren D percentage.

And as you can see, our Oren D budget will decrease as a percentage of revenue, but will grow dramatically in absolute numbers.

Next on our list of assumptions, are sales and marketing expenses. This is probably the most important set of assumptions in our income statement projection, and is quite complex because it is split across two different products for two different types of customer. New customers and existing customers. As a result, I am going to leave this until the next lesson. Instead, I'm going to move to general and administrative costs.

Historically, these have been between 15 percent and 12.5 percent for Tracker Time, dropping over time as revenue increases. Having studied similar startups in the past, however, I know that as you grow a business, the various levels of management and support staff will grow as well, over time. As a result, I'm going to leave general and administrative at 12.7 percent of revenue for the next five years.

To wrap up this lesson, I'm also going to add my general and administrative figure to the income statement. So I'll take revenue and I'll multiply by my percentage.

And again, copy across for the remaining cells.

As an exercise, try to fill in the B to C revenue, B to B revenue, cost of goods sold, gross profit, and gross margin, and Tracker Time's income statement projection. I'll leave my answer in the after file below this video.