Running a business
What is cost of sales and how is it calculated?
Cost of sales, sometimes known as cost of goods sold (COGS), is simply the cost involved in directly producing the goods or services that you actually sell. It’s important that you track the costs to ensure that you’re always profitable.
How you approach your cost of sales depends on whether your business sells goods or services. In this guide we’ll explain both approaches and give you the formulas for calculating cost of sales for both goods/products and services.
Cost of sales for goods and products
If you buy in goods to sell and don’t hold any stock, also known as inventory, then this is fairly straightforward. The formula is sales income – cost of goods sold = gross profit.
When you buy in more goods than you sell, it may look as though you have made a loss and have no tax to pay. but there’s a further adjustment to make in your accounts to reflect that you still own some of the items.
For example, you may buy in 500 items for £3 each and sell 250 for £5 each leaving 250 in stock valued at £3 each (stock is always valued at cost unless that is less than you would expect to realise by selling it).
That means, you paid £1,500 for the 500 items, and sold half those items for £1,250. But you still have 250 items in stock. So not quite as simple as when you sold all the stock.
Cost of sales formula for goods and products
Cost of sales = cost of items sold = opening stock + purchases – closing stock =
| PERIOD 1 | No. items | Sales/purchase price | Total value | |
|---|---|---|---|---|
| Sales | 250 | Items sold | £5 | £1,250 |
| Purchases | 500 | New stock you bought in | £3 | £1,500 |
| Minus closing stock because it has not been sold | 500-250 =250 not sold | Subtract the value of items not sold during as they are not part of the cost of sales in this period | £3 | -£750 |
| Cost of sales | 500-250=250 | Items sold | £3 | £1,500-£750=£750 |
| Gross profit | 250 | Items sold | £5-£3=£2 profit per item | £1,250-£750=£500 |
Cost of sales = £1,500-£750=£750 OR 250 items sold x £3 = £750
Purchases include everything that you have bought in the period but, as some goods are left in stock at the end of the period, they need to be deducted from the purchases figure to give the cost of sales. The effect of closing stock is to turn what may have looked like a loss into a profit, by matching the actual costs of the goods sold, to the income generated on sales in this trading period.
Also to note in this example is that the business has sold £1,250, but has to pay £1,500 so they have negative cash flow of £250.
In the next trading period the business has £750 of opening stock (250 items that cost £3). If they buy in 200 more items and sell 300 (so leaving 150 items unsold), the accounts would look like this:
| PERIOD 2 | No. items | Sales/purchase price | Total value | |
|---|---|---|---|---|
| Sales | 300 | Items sold | £5 | £1,500 |
| Opening stock | 250 | Items you had left at the end of last period | £3 | £750 |
| £750 | 200 | New stock you bought in | £3 | £600 |
| Minus closing stock because it has not been sold | 150 | Subtract the value of items not sold during this period as they are not part of the cost of sales in this period | £3 | -£450 |
| Cost of sales | 250+200-150=300 | Items sold | £3 | £750+£600-£450=£900 |
| Gross profit | 300 | Items sold | £5-£3=£2 profit per item | £1,500-£900=£600 |
Cost of sales = £750+£600-£450=£900 OR 300 items sold x £3 = £900
Typical items included in the costs of sales are purchases (adjusted for stock) but also direct labour, delivery and storage costs.
Cost of sales for service companies
If you sell services rather than goods then your cost of sales would be mainly labour, either salaries or subcontractor costs. Whilst you won’t have stock you may have “work in progress” at the end of the period representing work that isn’t yet completed and so can’t be sold or invoiced yet. The formula you need could look like this:
Cost of sales formula for services
Cost of sales = cost of time spent on all services or projects, complete or incomplete - time spent on all services or projects not sold
| No. hours | Sales/purchase price | Total value | ||
|---|---|---|---|---|
| Sales | 5 projects | £250 | £1,250 | |
| Hours worked | 60 | Total hours worked on all projects whether complete or incomplete | £25 | £1,500 |
| Minus closing stock because it has not been sold | 20 | Time spent on incomplete projects that have not been sold in this period so is not part of the cost of sales for this period | £25 | -£500 |
| Cost of sales | 60-20=40 | Time spent on the 5 projects that have been sold | £25 | £1,500-£500=£1,000 |
| Gross profit | 40 | Time spent on the 5 projects that have been sold | £1,250-£1,000=£250 |
Cost of sales = £1,500-£500=£1,000 OR 40 hours x £25 = £1,000
Whether you’re selling goods or services it’s important to keep an eye on the actual costs of what you are selling to ensure you are managing your pricing and volumes to make a profit which is why your cost of sales is such an important number to track.
This article is intended as general information only and does not constitute advice in any way. For any specific questions, you may want to consult your legal advisor or accountant.