How to Calculate Cost of Sales (With Formula & Examples)

In many cases, companies have been known to pat themselves on the back for growing their revenues without stopping to ask themselves one very important question: What was the actual cost of generating those revenues?

This is where the cost of sales calculation moves from being a mere accounting formula to becoming a decision-making tool.

In this guide, we will explore this topic from a business leader’s perspective.

What is cost of sales?

In essence, the cost of sales is the aggregate of all direct expenses incurred in the production or provision of a particular good or service that you have successfully sold. Or, in other words, it is the underlying cost of your income stream.

Thus, in discussing the direct cost, we are certainly not talking about general business costs. We refer specifically to the costs related to driving sales. In the case of a manufacturer, it covers production costs. In the case of a SaaS or services company, it covers the costs of delivery, including manpower and infrastructure costs to serve the clients.

Understanding this clearly sets the foundation for everything that follows.

What to Include in Cost of Sales

When working with groups, this is where most misunderstandings arise. Everything may not go here; just the direct costs that generate revenue should.

These are items that are usually included:

Cost of raw material or product

This refers to the actual cost of all materials that are utilized in making the product you sell. This is your first expense and will determine your margins. If there is any change in the cost of the raw materials, the direct selling cost will change as well. This usually turns out to be the highest cost in the case of products.

Labor cost

This refers to the cost incurred due to salaries that are being paid to the staff members who are responsible for generating income for your organization. While office staff members may not fall into this category, staff members in manufacturing or other functions do come under the head of direct labor costs. You must ensure that their efficiency is high.

Production costs

All the expenses associated with production or manufacturing come under this head. These include the cost of utilities, the cost of running machinery, etc. These are variable costs, but there might also be some semi-fixed costs included within these.

Costs of shipping and delivery

This cost is associated with the shipping of the product from your business place to the customer. The cost involves logistics, packaging, and shipping of the product to the customer. Due to increasing demand from customers for delivery, this cost might become very significant.

Costs of sales commissions

Sales commission is a bonus paid to the employees who make the sale of your goods or services. Since sales commission is based on sales and directly leads to income generation for the firm, it is classified under cost of sales. The firm should come up with an effective incentive structure for better results.

Costs of service delivery

If the nature of your business revolves around providing services rather than products, then the service delivery cost would be the total cost that goes into delivering that service. This might involve the cost of your consultants, the customer success manager, and others who are actively working on the client’s account.

The main idea I follow is that without this cost, there would be no revenue.

What is Excluded from Cost of Sales?

This is equally important to what is included. The error that I have observed repeatedly is loading the cost of sales with general overhead.

What should be excluded:

Marketing and advertising expenses

These are expenses that are undertaken for marketing purposes, to advertise or create demand for your product, not to complete the sale. Whether or not sales have been made, these activities can continue even after the sale. For this reason, they are not included in the calculation and are classified as operating expenses.

Salaries for administrative staff such as HR, finance, and management

Salaries paid to HR, finance, and managerial staff help with organizational functions but not with income generation. These positions are present in any organization, independent of the number of sales made. These individuals do not contribute to the production or delivery of a product or service; thus, they are not considered part of the cost of revenue. 

Rent, utility bills

Expenses such as rent, electricity charges, and other maintenance fees help the company operate but do not necessarily make sales. The company incurs these expenses independently of its sales performance. These expenses serve organizational functions that go beyond income generation; hence, they are categorized as indirect costs.

Subscriptions to software that is unrelated to delivery

Intranet software or software used for internal business operations, such as HR systems, financial management, and general productivity software, is not related to delivering value to consumers. Subscriptions to such software are continuous and not based on any sales activities. As a result, they do not have any direct relationship with generating sales and are not considered revenue-generating costs.

Research and Development

Research and development costs are linked with innovation and development to help the company grow and succeed. Such costs are incurred irrespective of the current sales and do not have any relation to delivering the existing products/services.

These are classified as operating expenses. If the cost is incurred even without any sale being made, it doesn’t belong here.

Cost of Sales Formula

At its simplest, the cost of sales formula looks like this:

Cost of Sales = Opening Inventory + Purchases − Closing Inventory

Let me break this down in a practical way. Here is how it can be explained in a practical sense.

Opening Inventory

Beginning inventory refers to the value of goods available at the beginning of an accounting period. The beginning inventory is made up of the unsold products from the last period. It sets the stage for determining the amount of inventory available for sales purposes.

Purchases

Purchases refer to extra inventory that one may buy or produce within a certain period of time. It involves all inventories that are acquired in order to meet customers’ needs. Therefore, it adds to the total number of inventories available for sale.

Closing Inventory

Ending inventory is the inventory that is still left unsold at the end of the period. It is subtracted since it has not helped generate income yet. Thus, it ensures that we can identify the cost of items sold.

In essence, it enables one to find the cost of goods sold rather than the purchased goods. It becomes easier to understand for such business enterprises that deal with products.

For those business enterprises dealing more with services, there is no opening/closing stock here. Hence, for them, the cost of sales formula for a service-based business is:

Cost of Sales = Direct Labor + Delivery Costs + Sales-Linked Expenses 

In this case, emphasis will be placed on people and efforts in order to create value rather than goods. This is because there is always a cost attached to the efforts required for the delivery of service, onboarding, and closing deals.

Examples of Cost of Sales

There are various ways of calculating direct cost (COGS). The calculation process may vary based on the nature of a particular business. Nonetheless, the general idea is always the same. That is why I would like to give a few practical examples in regard to calculating cost of sales within different types of businesses.

Manufacturing

When it comes to manufacturing, the cost of revenue encompasses all expenditures directly connected to the manufacturing process. It means that the costs of raw materials and wages of workers directly involved in the manufacturing process are part of revenue-generating costs.

Calculating the sales-related cost makes it easier to determine a pricing strategy. A business is able to evaluate the market capacity and decide on a pricing policy based on its assessment.

Small Business

In the case of a small business that buys some products, customizes them, and then resells them, the direct selling cost incorporates both purchasing and preparation expenses. It implies expenses related to the acquisition of the product from the supplier, as well as costs. 

E-commerce and Retailing

In retail or e-commerce, the business entity buys merchandise intended for resale. In the case of sales-related costs in retail and e-commerce, it consists not only of the price paid for the merchandise but also of costs associated with storing and delivering the products to the consumer.

As the nature of the business revolves around inventory, costs must be minimized to optimize profitability.

How to Minimize Cost of Sales

Reducing the cost of revenue isn’t about cutting blindly; it’s about improving efficiency. Here’s what has worked across teams I’ve worked with:

Make the supply chain efficient

If you make the supply chain process efficient, the costs incurred throughout the process, from sourcing of materials to delivery, will decrease. You can save costs through effective negotiation with suppliers, procurement in bulk quantities, and efficient management of inventory. Efficiency ensures that there is no waste or delays. This makes you more profitable in the long term and does not affect quality.

Boost sales efficiency

Your costs of sales can be decreased by ensuring that the sales team is making maximum sales with little cost and effort compared to the revenue made. Salespeople are trained effectively, given clear goals and objectives to achieve. It ensures that sales efficiency increases without much work being done.

Deliver efficiently

If you have efficient delivery methods, you ensure that there are fewer efforts involved in delivering goods to customers. This results in consistency in deliveries and efficiency in terms of costs.

Automate wherever feasible

There are instances when processes such as onboarding, support, or reporting can be automated. This would save effort, cut costs, and minimize errors in doing so. While automating all possible work is not the intention, it should serve its purpose to improve efficiency, reduce costs, and maintain the level of quality.

Match incentives to results

Incentives need to be based on the output rather than the effort spent. By tying commissions directly to performance metrics such as revenue or profitability, you motivate people to concentrate on what needs to be done in order to earn their commission. In turn, this helps you avoid paying too much while staying productive.

Monitor leading rather than lagging indicators.

Rather than focusing solely on the outcome, which may be the sales revenue, monitoring leading indicators provides more insight into the process and helps prevent issues even before they arise. It creates the possibility to make necessary adjustments and avoid unnecessary efforts.

Conclusion

In case there is anything that you should learn, it would be that revenue determines the growth rate, while the cost of sales determines the sustainability of the growth rate. A clear understanding of the calculation is something that gives you strategic advantages.

But then, when you master the calculation of this key metric, you will see something fascinating: good decision-making will happen almost automatically.

However, if you want to take things even further, especially in sales-driven environments, the use of JOP Edge will provide greater transparency regarding the process behind the scenes.