What does Cost of Sales mean and how is it calculated?

Understanding the numbers in your business is essential for all small business owners if you wish to scale a business. Most business owners understand the revenue and overheads element of a P&L but many struggle with the definition and understanding of a key element of the profit and loss which is cost of sales.

What does cost of sales mean?

The first question to answer here is what does cost of sales mean? Cost of sales (also referred to as Cost of Goods Sold (COGS) refers to the costs which have a direct impact on your ability as a business to generate revenue. Cost of sales includes, direct purchases of stock or materials, direct labour used to produce the product, cost of shipping the raw materials or stock to your premises and other direct costs.

How to calculate cost of sales

In order to know how to work out cost of sales accurately, you first need to ensure you are including ALL costs that directly relate to the revenue generated by your organization.

Examples of this include: stock purchases, packaging or for service business this may include software costs or certain labour costs.

Cost of sales does not include indirect costs such as marketing, accountancy fees or telephone costs therefore will have a higher degree of variable costs due to being directly impacted by the sales that the company creates. Cost of sales does include some fixed costs such as salaries but in most cases it will consist entirely of variable costs.

Whilst cost of sales has a fairly simplistic formula to calculate, some elements are more complicated than others. The main complication usually arises when attempting to calculate the stock figure. Stock is calculated in the following formula: Opening Stock + Purchases - Closing Stock.

Once you have this figure you can add all your cost of sales categories together to calculate your total cost of sales.

Using cost of sales to calculate gross margin/profit

By calculating the total cost of sales you will be able to then use this to work out the gross margin/profit your business is operating at. This is a critical formula for all businesses as this needs to be high enough to cover your overheads in order for your business to make a profit.

To calculate gross margin you can use the following formula: Total Revenue - Total Cost of Sales = Gross Margin/Profit.

Why is it important to calculate and monitor cost of sales?

As mentioned above, cost of sales relates to the costs that directly impact the revenue generation of your business. This therefore makes this a vital calculation when running a business. When scaling a business you MUST understand the costs of your business and in general terms your overheads will stay daily fixed as your sales increase whereas your cost of sales will increase directly with an increase in sales. It is therefore essential to keep a control of this and ensure it is monitored as a KPI regularly.

Examples of cost of sales

Many businesses will have different costs which make up cost of sales, here are a few examples of different industries:

Retail - the cost of the stock purchased that is then sold on to customers.

Restaurant - the cost of ingredients to make the food sold and the cost of staff that run the restaurant.

Manufacturing business - Cost of raw materials to produce the products sold and the cost of staff on the manufacturing line.

Read next:

• What is gross profit and how is it calculated?
• What is net profit and how is this calculated?
• What are the three main profitability ratios and how do you calculate them?
• Turnover vs Profit: what’s the difference?
• Revenue vs Income

About the author

Joe David, Founder & CEO, Nephos Accountants

At Nephos we believe that there’s a better way to grow your business. It’s time to bring your accounting into the digital realm, giving you greater control and clarity. The word ‘nephos’ is Greek for cloud, and nephologists study clouds to understand weather patterns. Like nephologists, we focus on the data held within the cloud, looking for patterns and movements that allow us to make the right financial forecasts and predictions. Nephos was built on the principle that technology can, and should, work harder for your business. Compliance is just one side of the coin – we don’t just help our clients to make sure they’re following the rules, we use our knowledge and insights to ensure they’re building for the future.