What is cost of sales and how do you calculate it?
Cash flow can be hard to manage when you don’t know how money moves around your business. And one of the most critical metrics you must measure for this task (especially when selling physical products) is cost of sales.
Keeping your finger on the pulse of your financial data doesn’t have to be daunting. In this article, we’ll walk you through what cost of sales is and how to calculate it.
Table of contents
- What is cost of sales?
- What to include in your cost of sales
- Cost of sales formula
- Other considerations for cost of sales
- How to interpret your cost of sales
- Expert insights
- Confidently calculate your cost of sales
What is cost of sales?
Cost of sales, also commonly referred to as cost of goods sold (COGS), is the total cost it takes to manufacture, create and sell a product or service.
While the definition of cost of sales is straightforward to understand, the calculation can be complex depending on your products. The cost of sales formula includes various direct and indirect costs, which can complicate the calculation.
Because cost of sales is considered a “necessary expense” to keep your business running, you must include it as an expenditure on income statements. You’ll also need cost of sales to calculate your company’s gross profit and gross margin.
To recap, the key takeaways are:
- Cost of sales is the cost of producing the products or services your company sells
- Cost of sales is deducted from sales revenues to calculate gross profit and gross margin
Top Tip: Cash flow is the lifeblood of your small business, no matter what stage you’re at. A cash flow forecast can predict your financial situation and help you make smarter business decisions. Check out our guide on what a cash flow forecast is and how to create one 💳
How does cost of sales differ from COGS?
Cost of sales and COGS (cost of goods sold) both refer to the expenses involved in producing merchandise or services. The terms are often used interchangeably, even by accountants, but there is a subtle difference you should know about.
It comes down to which term you put on your balance sheet, and this depends on the type of business you run.
- Retailers and service-only providers: Retailers and service-only providers usually put the term ‘cost of sales’ on balance sheets because it’s often difficult to directly tie operating expenses to a sale
- Manufacturers: Manufacturers prefer to use the term ‘cost of goods sold’ on their balance sheets
Furthermore, some businesses will use both terms on their income report. For example, a business might use both terms to report income if they provide services and sell products.
How does cost of sales differ from operating expenses?
Operating expenses (OPEX) refer to costs companies face as they operate.
Here are some examples of typical operating expenses for small business owners:
- Office stationery and equipment
- Utility bills
How does this differ from COGS?
When calculating operating expenses, you wouldn’t include any cost that occurs due to the production of any goods or services. COGS and cost of sales exist to include your manufacturing costs.
Selling, general and administrative expenses (SG&A) are closely related to operating expenses, but you include them as an individual line item on your balance sheet. These are costs that include all business expenses not related to creating a product or service, such as management and delivery costs.
How does cost of sales differ from cost of revenue?
Cost of revenue refers to any and all expenses involved in delivering a product or service to customers. As such, it extends beyond the manufacturing costs covered with COGS to include marketing and distribution expenses.
Examples of cost of revenue expenses include:
- Direct labour
- Cost of shipping
- Raw materials
The service industry typically favours this metric because it’s a more comprehensive report of the cost to provide the service.
Top Tip: To ascertain the financial health of your company, you need to understand the three main financial statements. To learn about balance sheets, income statements and cash flow statements, as well as general accounting processes, check out our complete guide to accounting for startups 📏
What to include in your cost of sales
To calculate your cost of sales, you must ensure you include the cost of any raw materials and goods bought for resale and that you used during the accounting period.
Before we look at the cost of sales formula, let’s explore the three values you’ll need to complete the calculation: beginning inventory, ending inventory and new inventory.
Beginning inventory for the year
Your beginning inventory includes products you have when you start a new accounting period, which is often when you begin a new tax year. This amount will correspond to what your inventory is worth.
Then there are purchases. Purchases are the new products you buy or produce to add to your inventory throughout the year.
The term ‘beginning inventory’ encompasses several items, including:
- Inventory leftover from the previous year (ie, products that didn’t sell)
- Raw materials used to make your products
- Related supplies (ie, packaging)
To establish a starting point for your cost of sales calculation, you’ll need the value of your beginning inventory for your accounting period. Calculate this number with your accounting records and use it in your beginning inventory calculation for your current sales period.
Let’s look at an example of how to calculate beginning inventory:
Linda runs an apparel business and relies on a third-party supplier to produce the t-shirts she sells.
Last year, Linda purchased 1,000 t-shirts and sold 500 of them. It cost Linda £3 per t-shirt. So, Linda’s cost of sales last year would be:
Cost of sales = Cost to produce each product X Number of products
£3 X 500 = £1,500 (Cost of sales)
At the end of the year, Linda was left with 500 unsold t-shirts. Therefore, she would calculate her ending inventory as follows:
Ending inventory = Cost to produce each product X Number of products
£3 X 500 = £1,500 (Ending inventory)
She also ordered another 600 t-shirts as new inventory for the upcoming year, which cost her £3 each.
New inventory = Number of new products X Cost to produce/purchase each product
600 X £3 = £1,800 (New inventory)
To accurately calculate Linda’s beginning inventory, we first need to add up Linda’s ending inventory and cost of sales from the previous year.
£1,500 + £1,500 = £3,000
Now, we can get Linda’s beginning inventory for the new sales year by subtracting the cost of those new t-shirts she ordered from the ending inventory figure above:
£3,000 – £1,800 = £1,200
Linda’s beginning cost of inventory for this year is £1,200.
As we covered above, your ending inventory is the value of the product in stock at the end of your accounting period. Businesses typically determine this by taking a physical count of inventory at year-end.
Going back to Linda, her ending inventory was the value of all the t-shirts she had left at the end of her sales year.
To recap, the calculation is:
Ending inventory = Number of products X Cost to produce each product
Linda had 500 leftover shirts that she purchased for £3 per piece, so her ending inventory calculation is:
500 X £3 = £1,500
Top Tip: If you want to save money for your business, pay the correct amount of tax and improve the overall health of your SME, you need to manage your expenses effectively. To learn more about business expenses, what you can claim back and how to do so, read our guide on what expenses are and how small businesses can manage them 😀
Cost of sales formula
Now that you have a deeper understanding of what contributes to your cost of sales, let’s put all of them together into the final formula:
Cost of sales = (Beginning inventory + Purchases) – Ending inventory
But before we dive into an example, your cost of sales formula will vary depending on how you (or your accountant) manage your inventory cost method.
Do you typically sell items that were manufactured or purchased first, last or neither?
The first three formulas apply to standard inventory, whereas the fourth is for unique goods:
- FIFO (First In, First Out)
- LIFO (Last In, First Out)
- Weighted average cost
With the FIFO method, the earliest manufactured or purchased goods are sold first. Given prices tend to go up over time, you will sell your least expensive stock first—first in, first out.
This method is best if you sell products that have a short shelf life.
The LIFO inventory cost method is the opposite of FIFO. With this method, the most recently manufactured or purchased goods are sold first.
During a period of inflation, where your more recently purchased items came at a higher cost, you will sell your inflated items first—last in, first out.
Weighted average Cost
With this method, the average cost of all goods is used, regardless of when the items were manufactured or purchased.
The weighted average cost method is ideal if you sell mass-produced items.
Here’s an example of how your cost of sales will vary depending on the inventory cost method you use:
Example of cost of sales formula
With the previous information, you now have a high-level understanding of the cost of sales formula, its three main components and how to put them together.
To calculate a true cost of sales, we need to include direct and indirect costs. These can be defined as:
- Direct costs. The costs incurred sourcing materials and building your products.
- Indirect costs. These include the cost of promoting your products, employees, software and other overheads.
The cost of sales formula allows businesses to calculate how much they spend to create and sell their products or services, regardless of whether they manufacture the products themselves or simply resell.
Calculating cost of sales also allows you to see exactly how much you’re spending per product to make a sale (and ensure you price products accordingly). And remember, you’ll also deduct the cost of sales on your business tax return, helping your bottom line. So, getting this number right is crucial.
When examining the cost of a product, you must consider more than the superficial cost to buy or manufacture it. You’ll need to include multiple direct and indirect costs into this number, including the following.
Direct costs: Related to production or purchasing products for resale
- Cost of raw materials (if you make your products)
- Any supplies needed for production
- Overhead costs related to production (eg, if you rented a facility for a short time to manufacture your product, the rent would fall under direct costs here)
- Cost to purchase products for resale
- Cost of all packaging
Indirect costs: Related to facilities, Equipment, Administrative and Labour
- Costs to store products (eg, storage facilities)
- Wages for salespeople
- Distribution costs
- Salaries for managers who oversee production
- Any equipment for administrative work
- Any depreciation on equipment used to produce, store or package products
Once these costs are factored into the cost of producing inventory items, it’s easier to calculate the cost of sales accurately.
To walk you through the cost of sales formula, let’s refer to our example with Linda’s t-shirts (assuming direct and indirect costs have been included in these calculations).
Cost of sales = Beginning inventory + Purchases – Ending inventory
Cost of Sales = £1,200 + £1,800 – £1,500
Cost of Sales = £1,500
Based on this cost of sales formula, Linda’s cost of sales for her T-shirts is £1,500.
Other considerations for cost of sales
While there’s already more than enough to consider when calculating the cost of sales for a business, there are some additional things for you to keep in mind:
- If a business hasn’t generated sales, it can’t deduct from its cost of sales. Even when it’s purchased or manufactured products to sell.
- When valuing the cost of your inventory, don’t forget to factor in facility costs. After all, a business often pays rent and utilities for the location where products are made and/or sold. Those costs need to be accounted for to ensure you’re ROI positive.
- These calculations can be complex for a business owner to handle, which is why getting guidance from a small business accountant can go a long way. Consult with an accountant or bookkeeper to double-check your calculations or simply leave it with an expert.
Top Tip: Accountants and bookkeepers can provide unique insights into your financial situation and make informed suggestions for the future. To find out why you might need one, and which is better suited to your requirements, read our guide on the difference between an accountant and a bookkeeper 📤
How to interpret your cost of sales
You’ve calculated your cost of sales; now what?
There are various ways to interpret the cost of sales and what it means for a business.
The next time you calculate yours, think about the following issues and whether they might apply to your business:
- Pricing strategy. On a strategic level, your cost of sales can reveal a lot about your approach to pricing. If you find that your cost of sales increases from one year to the next, your net income will decrease as a result. To maintain a healthy profit margin, you need to keep your cost of sales as low as possible, which may mean adjusting your pricing strategy.
- Operational efficiency. A concerning cost of sales figure can also shed light on potential operational efficiency issues. A high cost of sales sum could be a result of inefficient manufacturing processes or slow labour. As such, knowing your cost of sales provides an opportunity to make operational changes that could increase your net profit.
Wesley has worked with an array of businesses in various industries as Finance Director, Managing Director, Group Financial Controller and Practice Accountant.
He and his team provide a multitude of support services to businesses across the UK. They help with things from outsourcing complete accounts departments up to placing a part-time or virtual Finance Director, helping to add structure, process, planning and profit improvement to small businesses.
Why is it important to calculate cost of sales?
If you want to manage the profitability of your business and add to your bottom-line profit, you must understand how to calculate and interpret your cost of sales.
To calculate gross profit in your business you must first consider the costs.
The costs in any business are spread between two main categories: cost of sales and overhead costs.
It is important to differentiate between the two to understand the true profitability of your business.
If you get the cost of sales right, then the overheads of your business should be relatively constant, allowing the cost of sales to increase and decrease in line with the sales of the business.
For a retail business that sells items, the cost of sale is the item itself, which includes the cost of getting it from your supplier to you and any expenses (eg, operating expenses, administrative expenses, direct labour costs) that make it sellable.
For a manufacturing business, this would include raw materials, time spent on manufacturing, and other associated production costs.
If you can reliably track your cost of sales, then you will be able to understand whether your trade is improving or not. By having clarity on what makes you money and what doesn’t, you can make decisions to improve your business’s profit.
Tips to keep on top of your cost of sales
Regularly compare your gross profit against a previous period. If this gross profit percentage decreases, you may need to look at your cost of sales to drive costs down with external suppliers or scrutinise the usage of material in this area.
Here are a few tips to help you do this:
- If you record time into your cost of sales, then try and keep to the budgeted time allowed for the job you are doing.
- Value engineer or switch products to keep costs down but ensure the quality stays the same.
- Quote or estimate correctly, as simple as it sounds, knowing that you have enough money above and beyond your cost of sales is key to keeping your costs down compared to your sales price.
- Regularly review supplier prices and compare against their competitors.
- Look at cost controls and improve where you can.
- Always look for improved efficiencies in the production process.
- Encourage staff to be more efficient and mindful of waste.
Top Tip: One of the best ways to prepare for extra costs is to budget effectively. Without a solid budget, it’s easy to get carried away with spending and assume future revenue will cover initial costs. Learn what business budgeting is all about, why it’s important and how to get started with our 8 steps to create an effective business budget 📑
Confidently calculate your cost of sales
Now that you have a better understanding of how to calculate your cost of sales, you can make more informed, data-driven decisions about your business.
The formulas and calculations we provided will help you figure out your profit margins, forecast your cash flow and maintain profitability.
Top Tip: Managing your cash flow is more important than ever. To learn how to master your cash flow and maximise your chances of getting paid on time, catch up on our Masterclass series and step-by-step guide to mastering your cash flow 📹
Photo by Ellicia, published on Unsplash