What is cost of sales in business?

Cost of sales, also known as the cost of revenue or cost of goods sold (COGS), tracks how much it costs a business to produce a good or deliver a service. It’s calculated by adding the value of your starting inventory and your purchases for the current year, then subtracting the value of your remaining inventory at the end of the year.

Knowing how to calculate this figure helps a business determine pricing, profitability, and future growth plans. That’s why in this article, we’ll examine the cost of sales definition and how it affects business performance. We’ll also discuss how to calculate it and how to determine if an expense should be included or not.

What does cost of sales mean?

Cost of sales measures the amount a business has spent to deliver a good or service. You may sometimes see it as cost of revenue or cost of goods sold (COGS), but all names generally refer to the same concept: determining the direct costs linked to producing your products or delivering your service.

There are three fundamental things you need to calculate the cost of sales:

• The value of any inventory you have from the previous period, also known as the starting inventory
• The total value of any purchases related to production, such as labour costs and raw materials
• The value of any leftover inventory you have at the end of the current period, also known as the ending inventory

Inventory may refer to something else, depending on whether the business provides services or tangible goods. Still, the idea is the same: figure out whether a particular service or product is profitable for the business or costs too much to make. (We’ll discuss this in more detail later.)

Any expenses not mentioned above, such as admin or HR salary, office rent, and taxes, are not included in the calculation. These are what are called indirect costs: expenses that relate to the overall business operation, not just production or service delivery.

What is cost of sales vs COGS?

While cost of sales and COGS are often used interchangeably, especially in informal settings, some accountants use cost of sales as a broader term to include direct service or sales delivery costs, particularly in service-based industries. Furthermore, certain businesses may prefer one term over the other, depending on the nature of their product:

• Service-only businesses (e.g., consultancy firms, marketing agencies) typically use cost of sales because they’re not selling goods; they’re selling a service. Their expenses include personnel salaries and any direct expenses involved when delivering their service to customers, such as travel costs.

• Manufacturing businesses use COGS because they sell tangible goods, with tangible items (e.g., raw materials) and labour costs as part of their operating expenses.

• Retailers who sell already-manufactured goods use cost of sales because they’re not involved in creating the goods themselves. Their expenses are focused on procuring inventory and the cost of selling those items.

A good way to remember when to use which term is the letter G for goods. If a business produces goods, it’s typical to use COGS. If there are no goods produced, it’s typical to use cost of sales.

How do I calculate the cost of sales?

There’s one general formula used to calculate the cost of sales in business:

Cost of Sales = (Starting Inventory + Purchases) - Ending Inventory

• Starting inventory refers to the value of leftover inventory from the previous period, as recorded at the beginning of your current accounting period.

• Purchases are the expenses your business incurred to produce your product throughout the accounting period. 

• • Keep in mind that “purchase” doesn’t just refer to tangible goods; it also refers to your employees’ wages (you purchased their time to create your product), software licences, and other non-tangible expenses related to delivering your product or service. Only software directly used in production or service delivery is included; general operational tools are considered indirect costs.

• Ending inventory is the value of any remaining inventory you have at the end of your current accounting period.

The cost of sales formula is tweaked depending on whether your business is service-only, manufacturing, or retail. In service businesses, the cost of sales is typically calculated by summing direct labour costs, materials, and other directly attributable service delivery expenses. There is no inventory component. Despite the slightly different formula, the purpose is the same: figure out how much it costs to deliver a service.

For more details on the various ways of calculating the cost of sales, head over to our guide here.

What is included in cost of sales?

Not all business expenses are included when calculating the cost of sales, so it’s helpful to know which ones are your direct and indirect costs.

One way to determine if a cost is included is to ask yourself: Do we still need to pay this cost if we didn’t produce this particular product or service? If your answer is no, then it’s a direct cost linked to production and is included in the calculation. But if your answer is yes, it’s an indirect cost and is excluded.

Here are some common expenses that are included when calculating the cost of sales:

• Raw materials and supplies
• Packaging costs
• Product storage and transport costs
• Wages for those involved in the manufacturing of goods or the delivery of services
• Software licensing
• Business travel expenses for service personnel

What isn’t included in cost of sales?

Here are some examples of indirect costs that are excluded from the cost of sales calculation:

• Operating Expenditures (OpEx), such as:
  • Non-production staff wages (e.g., admin, support staff, HR)
  • Utilities
  • Rent

• Strategic Capital Expenditures (CapEx), such as product research and development

• Non-operating expenses, such as interest payments and taxes

Why is cost of sales important?

Your company’s cost of sales is a key metric in determining profitability because it tells you whether you’re spending too much or just enough on production.

If your cost of sales is low, you have room to make a profit once you sell your product or deliver your service. It’s also a signal that you’re managing production costs well.

On the other hand, a high cost of sales can mean inefficient production processes or high production costs. This affects your profits because there isn’t much room between your costs and retail price. You’ll want to re-evaluate your supply chain and production processes to see where you can reduce costs.

Quickfire summary: What is cost of sales?

Cost of sales, also known as cost of goods sold (COGS), measures how much your business has spent producing your product or delivering your service. You find this figure by subtracting the value of your remaining inventory for the year from the value of your starting inventory and any production-related expenses. 

Here’s the formula:

Cost of Sales = (Starting Inventory + Purchases) - Ending Inventory

The cost of sales formula differs slightly for service-only businesses, as their main expenses are personnel salaries and unpaid project invoices instead of tangible inventory. However, even though the expenses seem different, the end goal of calculating the cost of sales remains the same.

Regardless of your business type, knowing your cost of sales tells you how profitable your operations are. A low cost of sales signifies efficient processes and well-managed production costs, resulting in more profit once you sell your product. 

Meanwhile, a high cost of sales shows signs of production inefficiency and rising supply costs, ultimately affecting your bottom line.