Making a million dollars in sales doesn’t mean you’re pocketing a million dollars. To understand your true profits, you must subtract what it costs you to make or acquire the products or services you sell.
How much you make comes into focus when you learn how to account for your cost of sales. This key metric represents the direct expenses tied to providing services and producing or purchasing goods — how much you’ll ultimately profit.
Here’s how to calculate your cost of sales and why this critical figure impacts your bottom line.
Cost of sales versus cost of goods sold
Cost of sales is what many organizations refer to as cost of goods sold (COGS). But while you’ll often see these terms used interchangeably, there’s a subtle difference.
COGS generally refers to the direct costs involved in the production of goods — things like raw materials, labor, and manufacturing overhead. It’s most relevant to businesses that deal with physical products, like manufacturers and retailers.
Cost of sales is a broader term that’s relevant not just to manufacturers and retailers but also to service-based businesses. If your company incurs direct costs like wages for the employees who provide the service, those expenses fall under your cost of sales, while COGS doesn’t apply if you don’t sell any physical goods.
One important thing to note is that direct expenses are what’s included in cost of sales and COGS figures, not indirect costs — expenses that support the business’s overall operation but aren’t directly tied to producing goods or providing services. So, while things like rent, utilities, and administrative salaries do impact your bottom line, they’d usually fall under operating expenses instead of cost of sales.
Cost of sales in action: 3 real-world examples
To get a better sense of how cost of sales works, let’s look at a few real-world examples across different sectors.
Manufacturing
Imagine a custom furniture maker who builds everything from scratch. Their cost of sales would include the price of raw materials like wood, hardware, and fabric, along with the wages paid to the carpenters who craft each piece. The electricity used to power the tools and any finishing touches like varnish would also fall under cost of sales.
Professional services
Cost of sales would look a little different for a marketing agency that offers services like social media management, web design, and advertising campaigns.
The wages paid to graphic designers, copywriters, and strategists who work directly on client projects would count toward the cost of sales. If they had a direct tie to delivering services, you could also include things like analytics platforms or the software licenses required for design tools. But something like rent for the office or accounting services and other general overhead costs wouldn’t be included.
Retail
Say you run an online clothing store. Your cost of sales would include the wholesale price of the clothing you stock, along with shipping costs from the supplier to your warehouse. It would also cover any expenses tied directly to preparing items for sale, like packaging and labels.
If you hire staff to manage your online store’s order fulfillment, the related direct labor expenses would be considered part of your cost of sales as well.
How to use the cost of sales formula
Whether you’re looking to calculate COGS or your cost of sales, the formula is pretty straightforward:
Cost of Sales = Beginning Inventory + Purchases (or Direct Costs) – Ending Inventory
This calculation is crucial because the solution appears directly on your income statement, helping to determine your gross profit. By subtracting the cost of sales from your total revenue, you can see how much of your earnings are left after covering the direct costs of producing goods or services.
Here’s how each part of the formula breaks down:
- Beginning inventory: The value of the goods or materials you had in stock at the start of a given period (usually the beginning of the fiscal year or quarter).
- Purchases (or direct costs): The additional expenses you incur throughout the period, like inventory, raw materials, or any supplies you rely on to deliver services.
- Ending inventory: The value of your remaining inventory at the end of the period.
To calculate your cost of sales, add your beginning inventory and purchases together, then subtract the value of your ending inventory. The result is your total cost of sales for that period.
Here’s an example: At the beginning of the quarter, your retail store has $50,000 worth of clothing in stock. Over the next three months, you spend $20,000 buying more inventory. At the quarter’s close, $15,000 worth of clothing remains. Your cost of sales would be:
$50,000 (Beginning Inventory) + $20,000 (Purchases) – $15,000 (Ending Inventory)
= $55,000
That $55,000 represents the total cost of the goods you sold throughout the quarter. You can then subtract this figure from your total sales to find your gross profits for the quarter.
How to reduce your cost of sales
You can see how a higher cost of sales number affects your bottom line. That means that reducing the direct expenses tied to your goods or services makes your business more profitable.
But how do you turn that goal into a reality? These seven strategies can help.
1. Negotiate better deals with suppliers
Building strong relationships with your suppliers gives you more leverage when it comes to negotiating prices. Whether you’re buying raw materials or wholesale inventory, securing discounts or more favorable payment terms directly reduces your cost of sales.
2. Buy in bulk
If you can accurately forecast demand, purchasing materials or products in bulk is often a great way to save money. Just make sure you’re not buying so much that your inventory turnover ratio suffers — if that number drops too low, it could mean you’re sitting on excess inventory, which ties up cash and increases holding costs. The key is to find a balance between taking advantage of bulk discounts and maintaining a healthy turnover to prevent keeping too much stock on hand.
3. Optimize inventory management
Avoid overstocking or understocking by tightening up your inventory management practices. Tools like a perpetual inventory system or just-in-time (JIT) inventory can help you track stock levels more precisely, reducing waste and minimizing inventory costs.
4. Streamline production processes
Improving production efficiency cuts manufacturing costs. Wherever possible, try identifying bottlenecks, reducing material waste, and automating processes. The more you streamline operations, the lower production costs will be.
5. Outsource strategically
If manufacturing, order fulfillment, or other aspects of your business are driving up your cost of sales, look into outsourcing those tasks to specialized providers to reduce expenses. Just be sure the savings outweigh the potential downsides, like reductions in quality or flexibility.
6. Improve employee training
Well-trained employees are more efficient and less likely to make costly mistakes. Invest in regular training for every worker involved in the production or service delivery process. The fewer errors they make, the lower your overall cost of sales will be.
7. Reevaluate pricing strategies
If you consistently struggle to maintain a healthy profit margin, consider raising prices — especially if you offer a premium product or service. When paired with cost-saving strategies, a modest increase in price can quickly enhance your profitability without scaring away customers.
8. Reduce energy consumption
For businesses with high production or operational costs, cutting energy use can make a big impact on your cost of sales. Investing in energy-efficient equipment or adopting greener warehousing practices is likely to lower utility expenses without compromising production quality.
Optimize your cost of sales with Fishbowl
Learning how to calculate COGS and cost of sales is an important first step in improving your profitability. But if you really want to decrease your inventory costs and operating expenses, you need an inventory management system that supports your goals.
Fishbowl is the all-in-one inventory management solution designed to help you control stock, warehouse operations, manufacturing workflows, and more. The platform also integrates with QuickBooks to promote financial visibility to keep you up to date on stock levels and sales.
Are you ready to take control of your inventory costs and gain end-to-end visibility over your operations? Schedule a demo of Fishbowl, the intuitive, scalable, and user-friendly inventory management platform.