Cash flow is vital for all small businesses, but if you don’t understand the internal movement of your company’s capital, cash flow becomes extremely difficult to manage. That’s why understanding how to calculate the cost of sales is so important, giving you the information you need to stay on top of your business’s financial health. But what is the cost of sales? Learn a little more about the meaning of the cost of sales with our comprehensive article.
What is cost of sales?
Cost of sales, also referred to as the cost of goods sold (COGS), represents the direct costs related to the manufacturing of goods/services that are sold to your customers. Cost of sales doesn’t include selling, general, and administrative (SG&A) expenses, while it also leaves interest expenses out of the equation. In short, cost of sales is a very important financial performance metric, as it tracks your ability to manufacture/deliver goods and services at a reasonable cost.
What should I include in a cost of sales calculation?
One of the main points about the cost of sales calculation that people get stuck on is which expenses need to be included, and which don’t. If you stopped paying for a certain expense and could still manufacture the goods or deliver the service, then that expense should not be included in your cost of sales formula. However, if failing to pay for a specific expense would cause production to grind to a halt, it should be included in your calculation. Here are some of the expenses that need to be included:
Raw materials or supplies needed for production
Cost of packaging for products
Cost of storing products/materials
Wages for employees involved in the direct manufacture/delivery of goods and services
So, what doesn’t need to be included in the cost of sales calculation? While this depends entirely on your business, as well as the sort of products that you’re manufacturing, the following items aren’t directly or indirectly involved in production, and therefore shouldn’t be included:
Customer success costs, particularly those related to up-selling
Commissions for your salespeople
Cost of specific overheads
Cost of product development
How to calculate cost of sales
There’s a simple cost of sales formula that you can use to calculate your company’s cost of sales:
Cost of Sales = Beginning Inventory + Purchases – Ending Inventory
For example, let’s imagine that a company has £15,000 of inventory on hand at the beginning of the month. Throughout the course of the month, the company spent around £5,000 on raw materials, wages, and delivery. With £9,000 worth of inventory at the end of the month, you can use the cost of sales formula to calculate your company’s cost of sales during the month:
Cost of Sales = £15,000 + £5,000 - £9,000 = £11,000
Understanding the importance of the cost of sales formula
As you can see, calculating the cost of sales formula is relatively simple, assuming you know what to include and what to leave out of the calculation. But what’s the benefit of studying the cost of sales so intently? Ultimately, knowing how to calculate the cost of sales is necessary for working out your business’s gross profit. Once you know your gross profit, you can determine how effectively you’re managing the manufacturing process and how much remaining revenue you’ll have to deal with other expenses, such as debt.
In other words, if you want to understand your business’s financial performance in greater depth, the cost of sales formula is vital.
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