Expense management

Cost of sales: What is it and how to calculate?

Apr 05, 2024

All about the cost of sales

Understanding the movement of capital is vital for any business. In this context, the Cost of Sales becomes a key component to get a grip on. 

This is because this metric represents all the direct costs or expenses that come with the processes of selling and manufacturing the goods or services offered by the company.

It is an important factor in determining the total Cost of Goods Sold (COGS) and ultimately, the overall profitability of a business.

Therefore, understanding the different elements that make up what is Cost of Sales, how to calculate Cost of Sales, and how it can be used to measure profitability is important for any business.

What is cost of sales?

The cost of sales is an important part of business accounting and is the total cost of producing and selling products or services. It includes the direct costs of producing or purchasing goods and services plus the related overhead costs.

Examples of direct costs may include materials, labor, shipping, and taxes, while overhead costs may include rent, utilities, and advertising. The cost of sales is used to calculate the company’s gross margin, which is the difference between its total revenue and the COGS.

It is an important metric for evaluating the financial performance of a company.

Things to consider while calculating cost of sales

When it comes to the cost of sales calculation, the confusion often lies in which expenses should be taken into account. Generally, expenses that are necessary for production or delivery services should be included in the calculation; these are expenses that, if not paid, would cause production to cease.

Examples of expenses that should be included are:

1. Raw material costs

Raw materials such as labor, equipment, and supplies are the first consideration when calculating the cost of sales.

2. Overhead costs

Overhead costs include rent, utilities, insurance, and other general and administrative expenses.

3. Variable costs

Variable costs are those costs that change depending on the number of products sold, such as sales commissions, shipping costs, and packaging costs.

4. Fixed costs

Fixed costs are those costs that do not change regardless of the number of products sold, such as marketing costs and advertising costs.

5. Labor costs

Labor costs include wages, taxes, benefits, and other employee expenses associated with producing the products.

6. Taxes

Taxes must be included in the calculation of the Cost of Sales, including any applicable sales taxes.

7. Discounts

Any discounts or incentives given to customers must be taken into account when calculating the Cost of Sales.

8. Freight and delivery costs

Any freight and delivery costs associated with the products must be included in the calculation.

Things not to consider while calculating cost of sales

When calculating the Cost of Sales, you should not consider or include any costs that are not directly related to the production or sale of goods or services. This includes expenses such as administrative costs, rent, utilities, legal fees, and other overhead costs.

Additionally, you should not include any costs associated with non-operating activities such as special projects, investments, and research and development. However, these may vary from industry to industry or even company to company.

How to calculate cost of sales

The formula to calculate the Cost of Sales (COS) is: 

COS = Beginning Inventory + Purchases - Ending Inventory

For example, if a business begins the month with $20,000 of inventory, purchases $15,000 of additional inventory, and ends the month with $25,000 of inventory, then the Cost of Sales formula can be calculated as COS = $20,000 + $15,000 - $25,000 = $10,000.

This would be the cost of goods sold and would be subtracted from the total sales to calculate the gross profit.

Do you know it is very crucial for every businesses to know about trade receivable? Check out our article to know more about what is trade receivable, it's importance and how to calculate.

Why cost of sales is important for a business

Helps determine profitability

Knowing the Cost of Sales meaning is important for a business because it helps to determine profitability. By understanding the COS, a business is able to understand the amount of money it is making from the sale of its products or services, and the overall profitability of the business.

This is essential for businesses to be able to remain sustainable and profitable.

Guides and helps pricing decisions

The COS guides pricing decisions as well. By understanding the Cost of Sales, a business can determine how much it needs to charge customers for its products or services in order to make a profit.

This helps businesses to remain competitive in the market, as well as ensure that they are making enough money to remain sustainable.

Helps identify inefficiencies

By understanding the COS, businesses will be able to identify where they are spending too much money or where they could be saving money.

This helps to ensure that businesses are able to operate as efficiently as possible and reduce unnecessary costs.

Facilitates budgeting and forecasting

The COS calculation is also important for budgeting and forecasting. By utilizing the Cost of Sales, businesses will be able to set realistic budgets and forecasts for their future expenses.

This helps businesses remain financially sound and ensure that they are able to plan for future expenses.

Helps and guides with tax planning

Lastly, the cost of sales can also help during tax time. Using COS, businesses will be able to accurately plan for their tax payments and ensure that they pay the correct amount of taxes.

This helps businesses remain compliant with the law and reduce their overall tax burden.

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