A definitive guide to the cost of sales (with definition)

By Indeed Editorial Team

Published 22 November 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Understanding how an organisation spends money is fundamental to efficiently using its resources. The cost of sales, or cost of goods sold (COGS), is one type of cost that an organisation incurs due to revenue-generating operations. Learning about COGS, including how to calculate it, can help you determine whether it's financially worthwhile for a business to continue selling certain products and services. In this article, we discuss what COGS is, outline how to calculate it and list some of the benefits of performing this calculation.

What is the cost of sales?

The cost of sales refers to the total costs involved in creating and selling a product or service. It's a key metric for any organisation, as it informs companies about their efficiencies and provides insight into the profitability of each product or service they sell. Retail companies and manufacturers often use this metric alongside service providers, such as law firms and insurance companies. All of these firms use COGS to track their performance and to determine where they can reduce their costs to improve their profit margins.

Businesses often use COGS in the same way as product cost due to their similarities. The key difference between these metrics, though, is that COGS appears on income statements, whereas product cost appears on balance sheets as an inventory item.

Related: Your guide to controlling cost in project management

How to calculate COGS

To calculate COGS, follow these five steps:

1. Determine the business's material costs

To calculate COGS, first determine the company's material costs. This primarily includes the raw materials that the company uses. For example, in a clothing company, this consists of the cloth, dye and threads used to produce the clothing. Companies also include machinery costs as part of their materials costs, as these costs involve physical items that contribute to the manufacturing of their products.

When completing this step, it's crucial to be thorough, as this is one of the most significant elements of the COGS calculation. Generally, it's easier to track these costs by continually adding them to the company's balance sheet as the business accrues them. Doing this helps with accuracy and makes it faster to calculate a business's COGS.

Related: What are cost drivers? (Types, analysis and significance)

2. Monitor labour costs

The next step involves monitoring the business's labour costs. These specifically include the labour costs accrued to produce each product. Generally, these costs are higher when producing high-value goods and using large machinery, as these goods demand more time and attention. Due to the significance of these costs, it's crucial that manufacturers consider the time it takes for their staff to design and test their products before deciding to produce them.

Including labour in this calculation is especially crucial for firms operating in a service industry. For example, in a law firm, the labour costs involved in producing a product, which in this case are its legal services, are much higher than a retail company's.

3. Understand company overheads

Company overheads include all of a business's other costs. This includes the rental, energy, transportation and shipping costs a business accrues when producing a specific product. Sometimes, some businesses exclude their overheads when calculating COGS, leading to less accurate calculations. Also, companies may include too many overheads when performing this calculation instead of the ones that specifically relate to that product.

For instance, rather than including the rent for all of the business's premises in this calculation, you want to instead establish the cost of having the space to produce the product itself to gain an accurate calculation. In this example, if the business uses 10% of its premises to produce an item, it may count 10% of the rent for these premises as part of the overheads for producing that product.

Related: Examples of overhead costs and how to calculate them

4. Record all sales figures

The next step involves recording all the sales figures for the product. This consists of tracking every product sale throughout a specific period, including products that the company sells at a price below the standard retail amount. Completing this process provides better insight into the revenue that each product generates. When doing this, track the number of sales alongside the amount of money the company raises, as this ensures you have accurate sales figures rather than relying on a calculation derived from revenue.

If possible, try to record the sales figures using an automated system. For example, you can use an EPOS system to digitally track each individual sale. By doing this, companies can make it easier to track this data, which can make it far quicker to calculate the COGS. Additionally, when tracked digitally, these figures are more likely to be accurate, leading to a correct COGS calculation.

Related: A list of best sales tools to achieve your targets

5. Calculate the COGS

When you've acquired all the necessary data, you can then perform the COGS calculation. Before completing this step, double-check the accuracy of your data to ensure the calculation produces the correct figure. Also, it's a good idea to perform this calculation several times to check that it's accurate. The formula for completing this calculation is:

COGS = Beginning inventory + purchases - ending inventory

By completing this formula, you can gain a better idea of the value that companies get from each of their products or services. With this information, businesses can determine whether their individual products or services generate enough profit for them to be financially viable.

Related: What is net cost? (With definition, formula and tips)

COGS benefits

There are several benefits of calculating COGS, including:

Presenting to executives

One of the main benefits of using the COGS metric is that it's an ideal measurement when presenting to company executives. Board members and company executives are interested in understanding how the business spends its money. Calculating COGS and presenting this measurement's findings, along with other metrics, shows these individuals clear insights into how the company is performing. With this calculation, company executives and board members can make critical business decisions concerning its products and services.

When presenting COGS, consider doing this engagingly, such as by using charts or graphs. Using graphs or charts that compare COGS over time, you can demonstrate the information in a way that the business's key decision-makers can easily understand.

Related: 10 types of company executives (plus duties and skills)

Finding inefficiencies

Understanding COGS data is an ideal tool for finding inefficiencies. For instance, if a business's COGS rises above inflation, there's a high chance that the company has inefficient production processes. By noticing irregularities after reviewing this data and investigating further, companies can potentially identify what's causing these high production costs and mitigate or remove these causes.

When completing this process, having significant attention to detail is beneficial. This ensures you find all the potential issues within a company's production processes. After investigating these inefficiencies, you may find that these cost irregularities occur due to external factors. Due to this, performing a thorough investigation is crucial before making any significant business decisions.

Related: What are financial processes and how to make them efficient

Performing product assessments

Product assessment refers to the process companies use to establish whether a product or service is successful. This specifically entails looking through the company's catalogue of products and determining which ones are viable enough to earn a profit. COGS plays a significant role in this process, as it allows companies to compare this metric with how much revenue each product generates to identify and remove products and services that aren't financially worthwhile.

While this metric is useful, it's crucial that a business balances COGS alongside other factors before deciding whether to reduce its offerings. For instance, it can be beneficial for businesses to review how the product contributes to the company's overall brand identity and strategic goals. Sometimes, these factors may outweigh the losses a certain product or service makes for the business, making it worthwhile to keep it as part of its offerings.

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