Cost of Sales: Definition, Importance & Examples

The cost of sales is often considered one of the primary costs that affect sales revenue and is critical in the financial management of organizations of different types and scales. It is, therefore, used to determine how much is spent in producing a syllable item. With an actual number in the cost of sales, many decisions can be made by the company, whether it is in terms of budgeting, taxation, or even in general analysis of the overall financial health of the company.

What is the Cost of Sales?

In simple words, the cost of sales is when you add Administrative or Office overheads, cost of production, and selling and distribution overhead to the Cost of Goods Sold (COGS).

Important Note: Cost of Goods Sold (COGS) is not Cost of Sales (COS)

Although these terms are often used interchangeably, there is a big difference between these two terms. COGS  specifically refers to the direct costs related to producing goods or obtaining inventory that has been sold during a particular period. On the other hand, COS not only includes the direct cost of goods sold but also other costs that are directly related to generating revenue, such as direct labor and direct overhead. Essentially, COS encompasses a broader range of expenses than COGS, as it may include additional costs associated with delivering the product or service to the customer.

Key Components of the Cost of Sales

The cost of sales is defined as the key concept in accounting that helps businesses decide the profit based on the expenditure in producing and delivering the products to customers.

It has two key components, and that is:

1. Direct Costs: As the name indicates, these costs include all expenses directly linked to the production of goods or services. They involve costs connected to raw materials, labor, and manufacturing overhead.

2. Indirect Costs: Sometimes, certain indirect costs are also related to the production process, and that’s why they are added to the cost of sales. The costs are admin expenses, shipping expenses, quality control expenses, and many more.

Why is the Cost of Sales Important?

For businesses, cost of sales (COS) is an important financial metric as it provides detailed information on many aspects of operations. Businesses can depend on this metric to make well-informed decisions and achieve financial success. Moreover, it also helps in assessing many things, like price, profit, inventory, and more.

Mentioned below are some reasons behind the importance of COS:

• Assessment of profitability: Profit is evaluated based on the revenue left after accounting for the costs related to producing or procuring goods or services. This is why the cost of sales is considered a critical indicator of a company’s profitability. It also tells how efficiently a company is converting revenue into profit.
• Setting Accurate Pricing Strategies: A business might fail to set a relevant pricing strategy if it lacks knowledge of the cost of sales (COS). When a business lacks any idea about COS, it might charge prices that are either too low or too high, which results in a lack of competitiveness.
• Decisions about Inventory Management: The cost of sales is important for a business to follow and monitor the value of inventory at the beginning and end of the accounting period. This calculation is very important in making tough decisions about stock levels, orders, and inventory replenishments.
• Preparation of Accurate Financial Reports: COS is a line item in the statement of financial expenses and the income statement. It is pivotal to preparing an income statement and providing an overall outlook of the organization’s revenues and expenditures. Mistrust with key stakeholders may arise if the business does not have COS information to follow accounting standards.
• Measuring the efficiency of operations: Gross profit margin is usually looked at in relation to COS. A higher profit value demonstrates that a company is doing a good job controlling direct costs. On the other hand, a lower profit value depicts a need for control.
• Finding areas to save money: When a cost of sales calculation is available, it becomes easier for a business to save costs in an organization. The COS information can be used to develop strategies for reducing production costs and boosting the company’s profitability.

How to Calculate Cost of Sales?

The cost of sales formula is mentioned below:

Cost of Sales = Beginning stocks + Acquired during the period costs – Ending stocks

Here, opening stock is expressed as the value of total stock available with the business at the beginning of the accounting period, including the value of goods that remained unsold even from the earlier accounting period.

Cogs or inventory costs relate to the cost of purchasing or manufacturing other stock. They involve the cost of the material used, the cost of labor, and anything else that is incurred on purchase or in the course of production.

The amount usually represents the total of the merchandise at close or the cost of goods not sold within the same establishment.

We are fully aware of the basic cost of sales formula that can enable us to arrive at the total cost of sales.

For instance, if a company’s inventory amounts to $30,000 at the beginning of a month, it then spends roughly $10,000 on wages for the acquisition of raw products and delivery services. It realizes $18,000 worth of inventory by the end of the month, so the cost of sales during the month can be arrived at using the cost of sales formula.

As we know,

Cost of Sales = (Beginning Inventory + Purchases) – Ending Inventory

So,

Cost of Sales = 30,000 + 10,000 – 18,000 = 22,000

However, a company needs to have the following data on hand to calculate the total cost of sales:

• Thus, the total direct materials for items to be sold would be.
• The total of expenses to acquire and hold inventory for sale.
• All the direct labor costs, such as wages and salaries, are paid to the individuals involved in product selling.
• Record all the sales data within the specified accounting period to ensure proper reporting of the company’s financial performance.
• Calculate net sales.
• Gross margin divided by net sales.

What Should I include in a Cost of Sales Calculation?

There is one critical aspect where issues with the cost of sales calculation are most often seen: which costs need to be assigned and which costs do not. If you stopped paying for a specific cost and you are able to continue to produce the goods or offer the service, such cost should be separate from the cost of sales formula. However, if excluding a specific expense payment would mean being unable to produce any goods, the amount should be included in the equation.

Here are some of the expenses that need to be included:

• Software licensing.
• Products that pass through the production process, such as materials and other resources, are used to create products.
• Pricing of packing for products.
• Cost of storing products/materials.
• Salary for workers who participate in the production/conveyance of tangible and intangible products.

What Not to Include in Cost of Sales Calculation?

Every business is distinctive, and therefore, every decision that determines the content and excludes items in the cost of sales formula is unique. Essentially, all the conditions of inclusion and exclusion interface with the type of business construction and the type of products to be manufactured.

Nonetheless, the following elements generally are not taken into account when calculating the cost of sales :–

• All the expenses which are not involved in production, either directly or indirectly.
• Expenses related to up-selling.
• Salary and commissions offered to the salespersons.
• Expenses are recorded in the sales and marketing department.
• Cost of specific overheads.
• Cost of product development.

Cost of Sales Examples

Some of the examples of cost of sales are mentioned below:

• Manufacturing: To understand cost of sales or COGS, a manufacturer sums up all the manufacturing costs that a firm incurs to produce goods. This can entail the sum of wages paid to the production staff, the cost of raw materials, or anything acquired that goes into product manufacturing.

After understanding a manufacturer’s cost of sales, it becomes possible to find out how much consumers are willing to pay for the products and how this manufacturer can price their products to enable them to achieve the maximum value worthwhile while at the same time making profits.

• Small Business: If a small business buys goods from a wholesaler, puts its stamp on the goods, and redistributes the product, then the expense of sales could be arrived at by totaling the purchase price of the product to other expenses made on the product to enable it to be sold. For instance, the cost of sales of a small business can be defined as the purchasing costs for inventory as well as the shipping costs of the received goods from the suppliers. Additionally, costs such as customization and repackaging of received units might be included in the relevant calculations made by a certain business.
• E-commerce and retail: In a retail or e-commerce business, inventory is bought from a wholesaler or directly from the manufacturer with the intent of reselling to the final consumers in a retail store or on the Internet. Sales expenses comprise the purchase cost, warehousing costs, and transportation costs of products to the final customer.

Cost of Sales VS Operating Expenses

Cost of Sales is very different from operating expenses, as it covers all the costs that are directly related to the production of goods and services. General operating expenses cover all the costs that are not directly related to the production of goods or services, but still, they are required to keep the company running.

Some examples of operating expenses are:

• SG&A (Selling, General, and Administrative Expenses): Overhead costs that are not directly related to production.
• Rent: Office space or warehouse space to store finished goods. Rent for a factory or production facility is considered the cost of sales expenses.
• Utilities: All utility expenses which are not directly related to production.
• Sales & Marketing: Advertising costs and base salary for the sales and marketing personnel.
• R&D (Research & Development): Trying out expenses for future product improvements.

Cost of Sales VS Cost of Revenue

A company’s cost of revenue is the same but not the same as the company’s cost of sales or cost of goods sold. The cost of revenue adds the total cost of manufacturing the product or service and also any distribution and marketing costs. Some companies use the cost of sales or the cost of goods sold, while other companies use the cost of revenue. This choice might change some expenses to and from the operating expenses menu of a company’s income statement.

Some example of the cost of revenue is mentioned below:

• Shipping costs
• Cost of sales
• Commissions
• Warranties
• Return
• Discounts
• Other direct costs

How to Minimize Your Cost of Sales?

The reason for minimizing your cost of sales is to increase the overall profitability of your business. The less cost invested in producing the sales, the better your profit margins get.

Below mentioned are some ways through which you can minimize the cost of sales:

1. Automate Manual Processes

Automation will lower the cost of your sales and increase the sales and productivity that will support your business’s growth. Around 30% of sales tasks are automatable and utilize current technology. Some of those tasks are order management, analytics and reporting, lead identification, and sales and operations planning.

Analyze your entire sales chain to recognize areas that will help you from automation. You can implement chatbots to generate leads, maximize your sales, and free up your sales team’s time. Chatbot Technology will offer major benefits to both your business and your customers.

Analytic tools can be used to maximize customer acquisition and involvement, make a more personalized customer experience, and decrease customer churn.

2. Reduce Waste

Search for opportunities to decrease physical waste and inefficiencies in your production processes. This will include raw material waste, damaged or stolen goods, and shrinkage.

If you think your material waste is high, look for ways to redesign your manufacturing process to reduce it. Operational time loss or delay in the shipping process can affect your sales cost.

Search for waste in all the links of your supply chain. Reduce waste inputs through the application of lean manufacturing, where waste can be characterized.

3. Remove Unnecessary Product Features

Altering the ingredients, components, or materials used in rendering the company’s products may impact the particular costs of sales.

A point to note when you are deciding to eliminate features as a means of cutting cost is which features are those you are being stripped of that your customers will not care about.

Investigate the need for consumers’ satisfaction with your products or services. What attributes and values do they seek? Is it low cost, or possesses some functions that are peculiar in some manner, or is it of high quality?

Knowing which product attributes are valuable to the customer would enable you to reduce those aspects that they do not find useful.

4. Leverage Suppliers

Have a conversation with your suppliers about better prices or discounts on bulk purchases. By leveraging suppliers, you can take advantage of economies of scale, which provide cost savings proportionate to maximizing production or sales.

To avoid compromising on the gains made through economies of scale, the following considerations should be made: Any cost advantage achieved through bulk purchases of inventory should not be wiped out by the increased costs of storage or the cost of holding inventory in large quantities.

It is also possible to negotiate with suppliers to improve the purchase order cycles to reduce inventory lead times. This helps you place small orders and occasionally lower the quantities of stocks you have to keep.

The cost of sales is the direct cost of producing a good, including all the expenses of the materials and labor used in producing the good. It’s a key metric that has a direct impact on a company’s profit. For businesses, it is crucial to manage their Cost of Sales to achieve higher profits. If your company has the potential to reduce the COS through more production process efficiency, it will surely become more profitable.