What is Cost of Sales?

Cost of Sales is simply the amount of money a business has had to spend in order to generate the sales it has made within a period. In a simple manufacturing business this may be the amount of stock they have had to purchase plus the delivery charges associated with getting the stock to the warehouse. In a business that provides a service to its customer, cost of sales may be the amount of staff time (and the associated costs) required to deliver this service.

Cost of Sales is found on the income statement within the financial statements. It is commonly referred to as COS or COGS (Cost of Goods Sold) . COGS is a term used more by manufacturing/buy and re-sell businesses as they will be producing physical goods. COS will almost always be used by service-providing business as it wouldn’t really make sense for them to use the term “cost of goods sold”.

How to Calculate Cost of Sales

For a really simple business, calculating the cost of sales is fairly straightforward. The below formula is used:

Opening Inventory + Purchase of goods – Closing inventory = COGS

The reason this works is that it allows us to capture the amount of goods which have actually been used in the year. If a business made a high amount of purchases within a year but no sales then all those purchases would still be in stock at year end, which gets deducted from the cost of sales amount. The COGS would therefore be £0 which is true – if a business made no sales within the year then they can’t have any associated cost of sales.

It is extremely important that COS/COGS only includes the amount of purchases for goods that were actually sold in the year otherwise the amount will not be true.

More complex businesses:

The above formula works for business that simply buy and sell goods. In the real world, business may make their own products or may not have any physical products at all (in the case of a business that provides services).

For a manufacturing business, the COGS will include items such as cost of raw materials, manufacturing staff costs, factory rent and many other items of what we call the “manufacturing overhead”.

For a business that provides a service, the COS will be items such as direct labour – the amount of staff time and associated pay costs for this time, staff expenses – maybe the fuel required for the staff to visit a client, and any other costs which are associated directly to making a sale.

Where Does Cost of Sales Go in the Accounts?

As cost of sales is used to calculate how profitable a business is, it goes within the income statement (profit and loss account). It comes before the operating expenses section of the income statement is taken directly away from revenue to calculate the gross profit.

Here is an example:

Revenue £20,000

Cost of Sales (£10,000)

Gross profit £10,000

What this is telling us is that while the business made £20,000 of sales for the period, it cost £10,000 to generate those sales and therefore, the business made a profit after COS of £10,000 – this profit is known as Gross Profit.

Why is COS so important?

Understanding the costs associated with sales is extremely important for a business. Gross profit (see example above) is one of the best ways to see how profitable a business’ products are.

If COS is too high, a business will notice this as the gross profit will fall. This can then be looked into and the relevant action can be taken (negotiating discounts, scrapping low profit products.)

Essentially, the COS is the ultimate indicator of how profitable a business can be provided that it is able to manage it’s operating expenses as well.

Many business will track COS on a product by product basis and this allows managers to understand which items really drive the bottom-line profit within the business and they can make decisions based on this.

Summary

In summary, COS is a valuable item for a business to understand when it comes to controlling costs and profit.

It is the amount a business has had to pay out in order to generate sales and is used to calculate gross profit.

Related posts:

Please see our other posts related to Cost of Sales:

What are Financial Statements?