There are numerous hidden costs associated with running a business. Almost three out of every five SMEs in the UK fail owing to cash flow issues. Knowing how to manage this can ensure that your company is successful and reaches its financial objectives. The cost of sales is an important factor to consider.
In this article, we’ll explain what the term “cost of sales” implies and how to calculate it correctly.
What is Cost of Sales?
The cost of sales, also known as the cost of goods sold (COGS), represents the direct costs associated with the manufacture of goods/services provided to your customers. Selling, general, and administrative (SG&A) expenses are excluded from the cost of sales, as are interest charges. In brief, cost of sales is a critical financial performance statistic since it measures your capacity to produce/deliver goods and services at a fair cost.
Why Cost of Sales Matters
Understanding the cost of sales allows firms to determine how profitable each transaction was.
While personnel costs are often easy to calculate, other costs can take beginners off guard. Freelance teams that begin by utilising their house as an office will enjoy high margins at first, but this will alter once they must pay office rent.
Monitoring the cost of sales assists business owners in identifying and addressing the factors that put a strain on their profit margins.
What Should I Include in a Cost of Sales Calculation?
One of the most common questions about cost of sales calculations is which expenses must be included and which do not. If you stop paying for a specific expense but can still manufacture the items or provide the service, that charge should not be included in your cost of sales formula. However, if failure to pay a specific expense might result in a halt in production, it should be factored into your assessment. Here are some of the costs that must be considered:
- Software licensing
- Raw materials or supplies needed for production
- Cost of packaging for products
- Cost of storing products/materials
Wages for personnel directly involved in the production/delivery of goods and services
So, what should not be factored into the cost of sales calculation? While this is largely dependent on your business and the type of products you’re producing, the following items aren’t directly or indirectly involved in production and, so, should be excluded:
- Customer success costs, particularly those related to up-selling
- Commissions for your salespeople
- Cost of specific overheads
- Cost of product development
Cost of Sales Formula
It can be difficult to know what to include in your cost of sales calculation. However, the cost of sales calculation is fairly simple:
Cost of Sales = Beginning Inventory + Purchases – Ending Inventory
In practise, the formula might look like this:
(£15,000 in inventory at the start of the month + £10,000 in purchases for the whole month) – £11,000 in inventory at the end of the month
Using the preceding formula, the monthly cost of sales is £14,000.
Having an accurate and comprehensive view of how much your firm spends on generating the goods you sell is critical to successfully managing your finances. Knowing your cost of sales allows you to budget more precisely, plan for growth more effectively, and make more informed business decisions.
How to Calculate the Cost of Sales?
Now that we’ve covered what the cost of sales is, what it includes, and the formula for calculating it, it’s time to look at how it’s calculated. If you look at the formula mentioned in the previous part, you will notice that there are various variables that determine the overall cost.
#1. Beginning Inventory
The beginning inventory consists of all of the items, raw materials, and other supplies for your goods that you already have at the start of the year (often the new fiscal year). The beginning inventory is calculated by multiplying the number of units available at the beginning of the year by the price per unit at the time these things were purchased.
For example, if you purchased 1,000 units at £10 a unit at the start of 2021, your initial inventory would be 1,000 * £10 = £10,000. The beginning inventory is included in the formula since you would use stuff from your inventory before acquiring anything new.
#2. Purchase of Raw Materials
Raw materials are the foundation of any product, and any raw material that isn’t currently in your inventory will have to be ordered, with the cost of ordering added to the cost of sales calculation. If you imported raw materials from another country, you must also include freight or shipment costs in the purchase price.
The cost of raw materials is computed in the same way as the initial inventory. You multiply the number of units purchased by the current price per unit. So, if you ordered 5,000 units of raw materials at £10 per unit, your raw material acquisition would be priced at 5,000 * £10 = £50,000.
#3. Labour Costs
Labour is another essential component of the manufacturing process, and its cost must be factored into the cost of sales to obtain a more realistic value. It is computed by multiplying the hourly salary you pay your employees by the number of production hours and human resources you have. Simply said, if the hourly rate is £10 and you have 100 people who put in 1,000 hours of work, you get £10 * 1,000 * 100 = £1,000,000.
#4. Manufacturing Costs
Manufacturing costs include hourly overhead costs, which include utilities and other resources utilised in the production process, as well as the number of production hours. Simply put, if your overhead cost per hour is £100 and your production hours are 1,000, like in the preceding example, you will receive £100 * 1,000 = £100,000.
#5. Ending Inventory
The final value is ending inventory, which is the total value of all products or things left at the end of your fiscal year. It is computed by multiplying the number of units sold at the end of the fiscal year by the current unit price.
Assume that 300 of the 1,000 units you acquired at the start of the year are still available, and the price per unit has risen to £15 from £10. Your ending inventory will then be 300 * £15 = £4,500.
When all of the fictitious values from this section are added together, the cost of sales looks like this:
Cost of sales = £10,000 + £50,000 + £1,000,000 + £100,000 – £4500
Cost of Sales Examples
Depending on the industry a company serves, cost of sales and cost of goods sold are employed in different ways. Let’s look at some cost of sales samples from various industries.
#1. Manufacturing
A manufacturer will calculate the cost of sales, or COGS, by adding all of the costs associated with manufacturing items. This can include tallying up production staff wages, raw material costs, and other purchases that have a direct impact on product manufacturing.
Once a company has determined their cost of sales, it may research how much the market is prepared to pay for its products and set a strategically competitive pricing that maximises profitability and sales.
#2. Small-scale enterprise
If a small firm buys items from a wholesaler, personalises them, and then resells them, you may compute the cost of sales by adding the purchase costs to the costs of preparing the goods for sale. A small business’s cost of sales calculation, for example, could include the costs of procuring inventory and shipping from its suppliers, as well as the costs of customising and repackaging the received goods.
#3. Retail and e-commerce
Inventory is often purchased from a wholesaler or manufacturer for resale in a retail outlet or through an online store in a retail or eCommerce firm. The purchase price, any storage costs, and the cost of transporting products to the consumer will all be included in the cost of sales.
How to Reduce Your Sales Costs
The goal of lowering your cost of sales is to boost your company’s overall profitability. The lower your production costs, the higher your profit margins.
There are various strategies to reduce sales costs, including:
#1. Make manual operations more automated.
Automation reduces sales costs while increasing sales and productivity, hence supporting corporate growth. Using current technology, approximately 30% of sales tasks can be automated.
Among these are the following:
- Order management
- Lead identification
- Sales and operations planning
- Analytics and reporting
Examine your whole sales chain to identify places where automation can help. Implement chatbots to assist generate leads, enhance sales, and free up the time of your sales team. Chatbot technology has numerous advantages for both your company and your customers.
Analytic tools can be used to boost client acquisition and engagement, provide a more customised customer experience, and lower customer turnover.
#2. Minimise waste
Look for ways to eliminate physical waste and inefficiencies in your manufacturing processes. This includes waste from raw materials, shrinkage, and damaged or stolen goods.
If your material waste is high, consider redesigning your manufacturing process to reduce waste.
Lost operational time or shipping process delays might potentially have a negative impact on your cost of sales. Examine all aspects of your supply chain for examples of waste. Use lean manufacturing techniques to reduce or eliminate waste wherever possible.
#3. Remove superfluous product features
In some circumstances, modifying the ingredients, components, or materials utilised to make your items may allow you to minimise your sales costs.
It is critical to ensure that while deleting product features as a cost-cutting approach, you should not remove product aspects that your customers value.
Investigate your clients’ motivations for purchasing your products. What characteristics and rewards do they seek? Is it low-cost, has unique characteristics, or is it of good quality? When you know which product features are crucial to your customers, you may selectively remove those that they don’t value.
#4. Make use of suppliers
Negotiate better prices or discounts on bulk orders with your vendors.
You can take advantage of economies of scale by leveraging suppliers, which offer cost reductions proportionate to increasing production or sales. Make certain that any savings from bulk purchases are not offset by increased storage fees or the additional carrying costs associated with stockpiling large quantities of inventory.
You can also collaborate with suppliers to reduce purchase order cycle times in order to enhance inventory lead times. This allows you to order less and cut inventory costs more regularly.
#5. Optimise inventory management
Inventory consumes working capital, reduces cash flow, and costs money to keep in storage. Goods may perish or become obsolete before they may be sold in various instances.
It is critical to carefully manage your inventory in order to reduce your cost of sales and boost your profitability. Inventory management software and an optimised warehouse can help you handle inventory more efficiently and reduce costs.
Aside from these advantages, inventory software enables you to make more informed purchase decisions based on historical data and demand estimates.
#6. Improve warehouse operations
Having well-organized warehouses and workspaces increases efficiency since employees are not wasting time looking for tools and equipment. Create a well-organized floor plan that facilitates operational flow and processes. Make use of vertical space to expand the size of your warehouse.
Ensure that personnel can quickly and safely access it with the proper equipment for effective storage and picking. Standardise your bins and maintain a nice and orderly appearance. Everything should be labelled.
Production, labour, and storage costs are all components of your cost of sales; an effective warehouse can lower your cost of sales by increasing productivity.
#7. Invest in your employees
Employee labour costs account for a sizable component of the cost of sales. While automation of manual jobs can reduce some of these labour costs, investing in employee development and technical skill upskilling can save you money in the long run.
Employees that are disengaged, disgruntled, and undervalued result in significant staff turnover. High employee turnover costs your company precious time, operational issues, decreased productivity, and the cost of hiring and onboarding new employees.
Training and development of your employee resources can result in better productivity, performance, and customer service. Invest in your employees to cut costs and increase earnings.
Is Cost of Sales a Profit?
Cost of Goods Sold is also referred to as “cost of sales” or “COGS.” The direct costs of items created or purchased by a firm and sold to consumers or other businesses are referred to as COGS.COGS is a business expense that influences the amount of profit a firm generates on its products.
Is Cost of Sales the Same as Expenses?
The cost of sales accounts for expenses incurred in the manufacturing of a product or service, whereas operational expenses account for how much a company spends on overhead costs. The cost of sales affects a service or product directly, whereas operating costs support the total firm.
Is Cost of Sales the Same as Gross Profit?
The difference between net revenue and cost of goods sold is the gross profit. Total revenue is the sum of all sales less customer returns and discounts. The allocation of expenses required to create the commodity or service for sale is referred to as the cost of goods sold.
Is Profit Calculated Before or After VAT?
In general, when performing computations using values that include VAT, it is best to eliminate the VAT element first.
Where Does Cost of Sales Go on a Balance Sheet?
COGS is frequently the second line item on an income statement, following after-sales revenue. To calculate gross profit, subtract COGS from revenue.
Conclusion
Competently managing your cash flow and operations is the key to increased profitability and, ultimately, survival for a small business. Gaining skill in calculating business costs can enable you to make more educated, data-driven business decisions.
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