How to calculate cost of sales for your business
When running a successful company, it’s crucial that you stay on top of how money flows in and out of your business. One of the key metrics you need to understand is cost of sales.
Assessing the financial health of your business can be a daunting prospect, but once you understand key terms, it’s easy to break the process down into easy-to-execute steps.
In this article we’ll talk you through the ins and outs of cost of sales, and why it’s such a vital concept for businesses.
What is cost of sales?
Also described as the cost of goods sold, cost of sales is a metric that measures the amount of money that goes into creating or acquiring the products you sell.
There are all sorts of expenses associated with running a business, from marketing to keeping the office fridge stocked. Cost of sales refers to the expenses directly involved in producing your goods.
For service-based businesses or those that don’t carry inventory, cost of sales is a less important metric.
How to calculate cost of sales
It might not be immediately obvious which expenses you should include in a cost of sales calculation and which you should leave out.
The simplest way to make the decision is to imagine what would happen if you stopped paying for a certain expense. Would you still have a product to sell?
If you can’t produce your product without a certain cost, you can feel confident that it should be included in your cost of sales calculation.
That doesn’t mean you should only include the cost of raw materials in your calculations. Manufacturing and storage costs, and even the cost of licensing software may be necessary to get your products made.
If your business doesn't make products but buys them to sell on, you will use the amount you paid your suppliers and the cost of shipping your products to your warehouse in your cost of sales calculation.
Other expenses may help increase sales, retain staff, and create a positive working environment, but if your product would still exist without them, they don’t count towards the cost of sales.
What is the formula for calculating cost of sales?
The formula for calculating your cost of sales is:
Cost of sales = beginning inventory + purchases – ending inventory
If you are calculating the cost of sales for a certain time period (eg the tax year), you need to figure out how much stock you had at the beginning and end of that period, and the amount of money it cost your business to produce or buy that stock. That’s your inventory.
‘Purchases’ refers to the cost of manufacturing or buying any new stock which was added to your inventory during the time period in question.
Why is cost of sales important for your business?
All businesses need to track their financial performance to ensure their continued success. If costs rise or profits fall, you need to know what adjustments can be made to put things right.
Cost of sales helps you understand how your product investment translates into profit for your business. Once you've calculated your cost of sales, you can also find out your gross profit, using the formula:
Revenue - cost of sales = gross profit
Note, to work out your net profit, you will need to deduct other expenses, including all operating, tax and interest expenses.
Once you know your cost of sales, and thus your gross profit, you can determine the efficiency of your business. Do you need to switch suppliers or raise your prices? How much money is left over to pay off debts? Is your profitability improving or declining over time?
Airwallex can help you manage your money across borders more efficiently
What's more, your Airwallex account is seamlessly integrated with Xero, so your bookkeeping will be updated automatically.
To see how we can help you stay on top of your business expenses, lower costs and maximise profitability, click below to watch a 3-minute demo.
Related article: Break-even analysis
Tilly manages the content strategy for Airwallex UK. She specialises in content that supports businesses in their growth trajectory.
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