How to calculate cost of sales for your business
To run a successful company, it’s crucial that you understand how money flows into and out of the business. One of the key metrics to stay on top of is cost of sales.
It can be a daunting prospect to assess the financial health of your business, but once you understand key terms, it’s not too difficult 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, the cost of sales represents all the expenses that go into creating or acquiring the products you sell.
There are all sorts of expenses associated with running a business, from marketing to stocking the office fridge. Cost of sales refers specifically to the expenses directly involved in producing your goods.
For service-based businesses or those that don’t carry inventory, this is a less important metric.
How to calculate cost of sales
It’s not always immediately apparent which expenses should be included in a cost of sales calculation and which should be left 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 there’s no way of doing without a certain cost while still producing your product, you can feel certain that it should be included in the cost of sales calculation.
That doesn’t mean you’re only looking at the costs of raw materials. For example, the cost of storing your product, paying for manufacturing employees’ wages, or licensing software that is necessary to get the item made are all essential expenses that the product couldn’t exist without.
If your business buys goods to sell on rather than manufacturing them, you will include the amount you paid suppliers and the cost of shipping the goods to your warehouse in your cost of sales calculations.
Other types of expenses may help increase sales, retain staff, and create a positive working environment. These may be vital to help your business grow in the long run, but the product could still be made without them, so they don’t count towards the cost of sales.
What is the formula for cost of sales?
The formula for calculating cost of sales is:
Cost of sales = beginning inventory + purchases – ending inventory
If you are calculating the cost of sales for a certain tax year or month, you need to figure out how much stock you have at the beginning and end of this period, and how much it cost your business to make or buy this stock. That’s the inventory.
'Purchases' refers to the cost of making or buying any new stock that was added to your inventory during the time period in question.
This calculation will give you a figure for how much you spent to produce the stock items you actually sold. You don’t include the cost of the stock you are still left with at the end of the time period.
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, they need to be aware of what adjustments need to be made to put things right.
Once you've worked out your cost of sales, you can calculate your gross profit using the formula:
Revenue - cost of sales = gross profit
Note, to calculate your net profit you will need to deduct other costs, such as 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
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: How to write a killer business plan
Tilly manages the content strategy for Airwallex. She specialises in content that supports businesses in their growth trajectory.
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