What is cost of sales? Definition and examples

The cost of sales method calculates the direct costs of goods sold, matching production or acquisition costs with the revenue from those sales. Commonly used in profit and loss statements, it provides a clear view of a company’s core performance by focusing only on the direct expenses, unlike the gross profit method, which includes all costs.

What are cost of sales?

The cost of sales method is a widely used method for calculating the costs of goods sold (COGS) in financial accounting. This method focuses on matching the direct costs of production or purchase of goods with the revenues earned from selling those goods. It is commonly used in profit and loss statements to provide a clear view of the company’s performance in terms of its core activities.

Unlike other costing methods, such as the gross profit method, the cost of sales method allows businesses to directly calculate and report the expenses that are directly related to the goods or services they have sold during a specific period. This helps businesses focus on the actual performance of their core operations, rather than including all operating costs in the calculation.

How does the cost of sales method work?

The cost of sales method works by recognising only the costs directly associated with the goods that have been sold during a given period. This contrasts with other methods, such as the total cost method, where all costs—both direct and indirect—are considered when calculating profit.

Here’s a breakdown of how this method works in practice:

1. Identify direct costs:

The first step is identifying the direct costs associated with producing the goods or services. These costs can include:

• Raw materials: The basic materials used in manufacturing a product.
• Labour costs: Wages paid to workers directly involved in production.
• Manufacturing costs: Costs associated with running production facilities, including machinery and factory overhead.

2. Match costs with revenues:

Once the goods are sold, the costs directly associated with those goods are matched with the revenue generated from the sale. This ensures that the financial statements reflect the real cost incurred to earn the revenue from selling those goods.

• This process allows the company to assess how efficiently they are managing their production or procurement processes and helps in understanding their profitability.

3. Calculate the gross profit:

After calculating the total cost of sales, businesses subtract this from the total revenue earned from the sales during the period. The result is the gross profit, which indicates how much money the business made from its direct activities (production or purchase) before accounting for indirect costs, such as overhead, marketing, and administrative expenses.

The cost of sales method explained with an example

Let’s break down how to calculate the cost of sales with a practical example:

Imagine a company that manufactures and sells bicycles. For the month of March, the company made total sales of £100,000. The direct costs associated with producing the bicycles, such as raw materials, labour, and manufacturing costs, amounted to £60,000.

• Sales revenue: The total income generated from the sales of bicycles = £100,000
• Cost of sales (direct costs): The direct costs for producing and selling the bicycles = £60,000

Calculating gross profit

To calculate the gross profit, we subtract the cost of sales from the sales revenue:

• Gross profit = £100,000 (sales) - £60,000 (cost of sales) = £40,000

The gross profit of £40,000 represents the amount the company earned from selling its bicycles, after accounting for the direct costs involved in their production. This figure reflects the efficiency of the company in turning its production costs into actual profit.

The gross profit is an essential measure for business owners, investors, and stakeholders to evaluate how well a company is performing with respect to its core activities.

Advantages and disadvantages of the cost of sales method

Like any accounting method, the cost of sales method has its advantages and disadvantages. It provides a clear and straightforward way to calculate profits based on direct costs but may not give a full picture of the company’s financial health.

Advantages

1. Clear profitability insight:

   • By focusing only on the direct costs, this method allows businesses to assess what the cost of sales is and how much profit they are making from their core operations, such as manufacturing, production, or sourcing. This clear view helps identify whether the company’s core business activities are profitable.
   • It’s easier for business owners to understand how effective their operations are in generating profits from direct sales activities.

2. Simplifies financial reporting:

   • This method provides a simplified approach to calculating profits since only direct costs are considered. Unlike other methods where all expenses (including overhead) are accounted for in the calculation, this method focuses on the fundamental costs of making and selling products.
   • It helps prevent overcomplicating financial reports and offers a straightforward way to assess the financial performance.

3. Better cost control:

   • Companies can identify which aspects of their production process are the costliest, allowing them to implement cost-saving measures. By focusing on the direct costs, managers can take actions to reduce waste, improve efficiency, and optimise resources in production.

4. Widely accepted:

   • The cost of sales method is widely recognised and accepted in accounting, making it easy for businesses to compare their performance against industry standards. This can help with benchmarking and understanding competitive positioning.

Disadvantages

1. Excludes indirect costs:

   • A limitation of the cost of sales method is that it does not account for indirect costs such as overhead, administrative expenses, or marketing costs. These costs, while essential to running the business, are excluded from the calculation, which can provide an incomplete view of a company’s overall financial health.
   • Therefore, while the gross profit figure is helpful, it does not represent the company’s net profit or final financial standing.

2. Less suitable for service businesses:

   • The cost of sales method is generally more applicable to product-based businesses. For service-orientated companies, where direct production costs are not easily quantifiable (e.g., professional services like consulting), this method may not be as effective or relevant.
   • In such cases, the total cost method or contribution margin method might be more suitable.

3. Requires detailed tracking:

   • Companies need to accurately track and differentiate between direct and indirect costs, which can be complex and require sophisticated accounting systems. This may be challenging for smaller businesses with limited accounting resources, especially if they do not have a robust inventory or cost tracking system in place.

Please note the legal disclaimer for this article.