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What is cost of sales?

February 8, 2023When it comes to keeping your small business health in check, cash flow is key. However, it can be hard to manage if you don’t understand how money moves around your business.One of the most important metrics you need, particularly when you’re selling physical products, is cost of sales. This number gives you vital information on the financial health of your business.In this article, we’ll explain more about what cost of sales includes and guide you through the cost of sales formula.

Cost of sales definition

You will frequently hear cost of sales also referred to as cost of goods sold, or COGS for short. It is the total cost it takes to create, manufacture and sell a product or service.It’s also worth considering what isn’t included in cost of sales. Cost of sales doesn’t include selling, general and administrative expenses (SG&A), with these items instead recorded on financial statements under operating expenses as a separate line item.COGS is recorded as a business expense and impacts on how much profit a company makes on its products. As a key metric used in measuring the cash flow of your business, it’s essential it can be found on your income statement as an expenditure, and can help small business owners estimate their company’s bottom line.

Depending on the nature of products or services your business sells, the calculation can be quite complex. The cost of sales formula includes different direct and indirect costs, which will affect how the number is calculated.Cost of sales is also used to calculate gross profit and gross margin as it is deducted from sales revenue.

How does cost of sales differ from COGS?

Both cost of sales and COGS refer to the production costs involved in producing goods or services. You will hear the terms used interchangeably, but there is a subtle difference between the two, which depends on which term you put on your balance sheet, as well as the type of business you run.

Retailers and service providers tend to use the term cost of sales on their balance sheets because it can be difficult to link operating expenses to a saleManufacturers tend to use the term ‘cost of goods’ sold, as they are producing products

What should be included in a cost of sales calculation?

One of the reasons why the cost of sales calculation may seem complicated is that it can be confusing as to which expenses you should include and which ones you should leave out.A way to remember what to include is to ask yourself, if you stopped paying for a certain expense, would you still be able to manufacture your products or deliver your service?If the answer to this is yes, then this expense should not be included in your cost of sales formula. However, if the opposite is true and your production would grind to a halt if a certain expense wasn’t paid, then it should be included.The following types of expenses should be included in cost of sales calculations:

Cost of raw materialsCost of items intended for resaleCost of components or parts used in the manufacture of a productDirect labour costsPackaging costsOverhead costs, such as gas and electricity for the manufacturing siteDirect labour costs for employees involved in the direct manufacture or delivery of goods and servicesStorage costs for components and stock (inventory)Shipping or freight costsIndirect costs, such as paying for a sales force or distributionSoftware licensing

What should be excluded from cost of sales?

The expenses you don’t need to include in the cost of sales calculation will depend very much on the nature of your business, as well as the sorts of products you’re making.However, as a rule of thumb, the following items aren’t either directly or indirectly involved in the production process and therefore shouldn’t be included:

Customer success costs – particularly related to up-sellingSales team commissionCosts associated with new product developmentSelling, general and administrative expenses (SG&A)

Cost of sales formula

The formula for calculating your cost of sales is as follows:

Cost of sales example

A company has £15,000 of stock on hand at the start of the month and spends £5,000 in direct costs on raw materials, wages and delivery.At the end of the month, it has £10,000 of stock.The calculation for this would be:Cost of sales = (£15,000 + £5000) - £10,000 = £10,000However, your cost of sales formula will vary depending on how you (or your accountant) manage your cost of inventory method.As your COGS is classified as an expense, you’ll need to record it in your ledger as a debit to the expense account and as a credit to either your asset or liability account.

Types of stock management and impact on COGS

The value of the cost of goods sold will depend on which inventory costing method your company uses. There are three methods a business can use when rotating or managing stock levels sold during a specific accounting period. These are as follows:

First in, First Out (FIFO for short)Last In, First Out (LIFO for short)Average cost (or weighted average) method

FIFO

First In, First Out is a valuation method used to determine stock rotation, where the goods purchased or manufactured earliest are sold first.As prices tend to increase over time, a company using the FIFO method will sell its least expensive items first, meaning this would result in a lower COGS value than if the LIFO method is used. Net income using FIFO stock management will tend to increase over time.

LIFO

As the opposite of FIFO, LIFO describes where the latest goods added to stock are sold first.During periods when prices are increasing, goods with higher costs are sold first, leading to a higher COGS value. Over time, net income using the LIFO method will tend to decrease.

Average cost method

This method involves calculating the average price of all the goods held in stock, regardless of when they were purchased or manufactured.The advantage of this is that is averages – or smooths out the total stock cost, meaning that the COGS value won’t be highly impacted by extremes of cost.

How to interpret your cost of sales

Once you’ve done your calculations and now have your cost of sales on your income statement, the next step is to analyse this data to see what it means strategically for your business.Your cost of sales numbers will be key to the following:

Pricing strategy

Your cost of sales can tell you a lot about your approach to pricing. If your cost of sales increases year on year, your net income will decrease as a result.You need to keep your cost of sales as low as you an in order to maintain a healthy profit margin. As a result, you may need to adjust your pricing strategy if your cost of sales is decreasing.

Operational efficiency

Your cost of sales figure can also point to potential inefficiencies with your operations. For instance, a high cost of sales could be as a result of inefficient manufacturing methods or slow labour.Having a good understanding of your cost of sales figure and being able to spot trends could give you the chance to make operational changes that will help to boost your net profit.

Limitations of COGS

Occasionally, unscrupulous accountants or managers have used COGS to tweak their inventory accounting, inflating their gross profit margins. The number can be altered by:

Adding higher stock manufacturing overhead costs than those incurredOverstating returns to suppliersOverstating discountsAltering the quantity of inventory in stock at the end of an accounting periodOvervaluing available stockFailing to write off obsolete stock

If inventory is artificially inflated, then COGS will be under-reported. This in turn will lead to a higher than actual gross profit margin and an inflated net income. Such practices can be spotted by checking for build-up of stock and stock levels rising faster than reported revenue.