What is the cost of sales and how is it calculated?

When running a business, it’s crucial to track your expenses to stay competitive and maintain profits. Your cost of sales (COS) is a key metric in driving success, as it indicates the amount you pay to produce and sell your goods or services over a specified period, such as a quarter or a year.

In this article, we break down the details of COS, explain its importance, and provide guidance on how to calculate it, among answering other frequently asked questions.

What is the cost of sales?

If you run a manufacturing, retail or distribution business, COS – also known as direct expenses – includes items such as raw materials, factory labour, inventory, shipping, and storage directly related to providing the product.

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If you’re running a service-based company, COS covers costs such as sales commission, software subscriptions, travel to client meetings, and wages for those directly involved in providing the service.

COS vs cost of goods sold (COGS)

COS is similar to another financial metric called cost of goods sold (COGS). The only difference is that retailers, wholesalers and manufacturers tend to use COGS, as their operations involve the production and sale of physical goods. Service providers tend to use COS because they do not have tangible goods.

Why is cost of sales important?

Most COS items are tax-deductible, so accurate calculations help ensure you don’t pay more tax than you need to. Regular monitoring and analysis of direct expenses can also help you identify ways to maintain efficiency, reduce unnecessary costs, and maintain a healthy profit margin.

If your COS rises without a similar increase in sales, that could impact your profits. Breaking down your COS figure allows you to identify where the problem lies. For instance, by investigating whether it’s because of an increase in raw material prices or labour costs.

What does this look like in practice?

If you run a restaurant, you could do this by breaking down the costs of your food and drink ingredients. If you find that the price of coffee is rising much faster than other ingredients, you might consider diversifying your menu to include items with stronger profit margins.

Or, if you’re a furniture manufacturer, you might break down COS into packaging, raw materials, factory labour costs, and transportation. If the analysis shows wage pressures are having the biggest impact on direct costs, you might look for ways to offset this by streamlining production.

Calculating COS can also help you:

• Identify positive changes, such as whether new software has impacted efficiency on service delivery or production lines, and how quickly it’s taking effect
• Keep tabs on inventory to spot shrinkage, leakage or previous stock miscalculations
• Report inventory figures to shareholders and tax authorities
• Forecast how stock levels could impact your tax liabilities for the year.

Cost of sales and gross profit

COS typically appears on a company’s income statement below the revenue figure. Subtracting COS from revenue gives you your gross profit, which is a key measure of how well you’re managing your labour and production processes.

When your business expands its operations to meet the growing demand for a product, doing so efficiently can lead to an increase in gross profit. However, suppose the costs associated with scaling production negatively impact your profit margins, such as hiring too many workers or investing in less productive technology. In that case, your overall financial performance may suffer.

What’s included in the cost of sales?

The key question to ask is whether the expense exists only because of the product or service being sold. If the answer is yes, you would usually include it in COS.

Your COS calculation should include:

• Materials and supplies directly involved in providing your product or service
• Labour costs associated with production, sales or service delivery
• Manufacturing and fulfilment expenses, including transport and storage, related directly to the products before they’re sold.

These items will differ depending on the type of business. For example, a solicitor’s COS might include partners’ salaries, software subscriptions, and travel to client meetings. A retailer’s might consist of inventory, warehouse workers’ wages, and delivery costs. A computer manufacturer’s COS might include the value of the assembly parts they hold, factory workers’ wages, and costs of delivering the items to retail partners.

Items not directly associated with a specific product or service and therefore excluded from COS typically include:

• General business overheads like rent and utility bills
• Non-direct expenses such as advertising
• Salaries for employees who don’t directly deliver your services, such as your finance and HR teams
• Interest payments, taxes, and legal settlements.

However, you’ll need to know these expenses for your net profit calculation, which is sales minus both COS and indirect expenses.

How to calculate the cost of sales

The formula for calculating COS will vary depending on your business type.

COS formula for product-based businesses

For retailers and manufacturers, it involves counting your starting and ending inventory, and purchases made during the period you want to measure:

COS = starting inventory + purchases during the period − ending inventory

The starting inventory is the value of your available stock at the beginning of the period, representing what was left over from the previous period. For retailers, it includes products ready to be sold to customers. For manufacturers, it includes raw materials, work in progress, and finished items waiting for sale.

Purchases include all costs associated with acquiring or producing the goods or materials you sell to customers during the period.

The ending inventory represents the value of any stock remaining at the end of the period.

Say you have a wholesale company selling auto parts and want to calculate COS for a whole calendar year. Your inventory and purchase data might be:

• Starting inventory on 1 January: £40,000
• Purchases between 1 January and 31 December: £30,000
• Ending inventory left over on 31 December: £20,000

The COS for the year is: £40,000 + £30,000 – £20,000 = £50,000

COS formula for service businesses

Firms that don’t hold inventory need to vary this formula to focus more on wages and subscriptions. Consider a fashion design business that wants to calculate its COS on a quarterly basis. It employs two designers, each earning £4,000 per month, and spends £200 on software subscriptions to assist them in creating their designs.

COS = £4,000 + £4,000 + £200 = £8,200 a month, or £24,600 a quarter.

How to reduce your cost of sales

There are several steps you can take to manage your COS and profitability. Here are a few strategies:

Pricing

Regular assessment of your direct costs can help you optimise your pricing strategies. If you observe COS increasing while revenue remains flat, it may indicate that you need to consider raising prices. COS can also help you test the effectiveness of these approaches, as well as experimental strategies such as discounting or value-based pricing.

Supplier negotiation

Developing strong partnerships with your suppliers can help you negotiate better terms and prices. Thorough market research, evaluating supplier performance, and seeking competitive bids can help ensure the best value for money.

Or consider other strategies such as buying in bulk, offering longer-term contracts, cobranding, and joint product development to help drive costs down.

Efficient inventory management and fulfilment

Many techniques are available to help you reduce excess stock, transport expenses and other costs associated with getting your product to customers.

Just-in-time (JIT)

For example, just in time (JIT) techniques minimise inventory by reducing the time it spends in your factory or warehouse. Modern warehouse management systems can help you track inventory in real-time, enabling you to avoid overstocking or understocking.

IoT and automation

Internet of Things sensors, along with computer vision drones and robots, can help you track stock in real-time and even integrate with AI programs to make smart suggestions for streamlining your warehouse, transport, and delivery operations.

Automation and outsourcing tips

For a manufacturer, analysing and automating production processes can help reduce waste, optimise resources, and increase efficiency. Lean manufacturing techniques or outsourcing parts of the process to specialist producers can also help maximise efficiency and reduce costs.

Why understanding COS matters for growth and decision-making

Cost of sales is not just a short-term business measure. Over time, it can provide valuable insights into longer-term business trends and profitability. Regular analysis can help small business owners identify patterns, such as changing demands, seasonal fluctuations, shifting production or material costs, and the effects of automation and AI. These can help you improve margins, spot trends early, and plan with confidence.

Understanding the relationship between COS and other financial metrics, such as gross and net profit, can guide decisions about your company’s strategic direction, including which product lines to pursue and how to invest now to improve productivity in the future. Ready to take your first steps in business? Explore our services for setting up a limited company today.