Cost of sales: Definition, formula, and ways to lower it
Get a better understanding of your finances by tracking your company’s cost of sales.
Published May 22, 2014
Last updated March 8, 2022
If you’re going to run and grow a successful business, you need to know where you’re spending money and how much you’re making back. Without the ability to view all the fine details of your cash flow, you risk making decisions blindly or without the proper context.
That’s why companies include the cost of sales in their balance sheets and income statements.
What is cost of sales?
Here’s a simple cost of sales definition: Cost of sales represents the cost of creating a product or service.
This sales metric is used to calculate gross profit. By subtracting the cost of sales from the sales revenue, you can determine the gross profit for a given time period. If certain costs aren’t vital to the manufacturing of your product or service, eliminating them will automatically increase your gross profit.
Elements to include in cost of sales
There are many different costs associated with the creation of a product or service. The specific expenses you include in your cost of sales depend on the process of manufacturing, storing, and delivering your product or service.
Here are the expenses most commonly included in the cost of sales.
- Cost of labor to create the product
- Cost of labor to provide the service
- Raw materials
- Overhead cost of running facilities for production
- Software licensing
- Cost of packaging
- Cost of storage
The following costs aren’t directly related to the cost of production, so they’re usually not included in cost of sales.
- Cost of distribution
- Administrative expenses
- Certain overhead costs (office supplies, rent, utilities)
- Consulting expenses
- Production equipment
Cost of sales will include a wide range of costs depending on your business, size, and what’s being sold. For instance, the cost of sales for a small consulting company will look much different from the cost of sales for a large shoe company.
How is cost of sales different for companies that provide services?
Lawyers, doctors, consultants, and other service providers don’t have a physical product to sell. They’re not selling goods that have been manufactured with raw materials with clear market value. Instead, they offer a service that has value depending on their skill level, speed, and convenience. When it comes to cost of sales, service-based businesses account for employee salaries and other costs related to producing their service, rather than tangible things like raw materials and packaging.
What is the difference between cost of sales and cost of goods sold?
Cost of goods sold (COGS) describes the cost to make products from raw materials or parts. Cost of sales, on the other hand, refers to the total cost to create a service or a product. Service providers would never include the cost of goods on an income statement because there are no goods to sell.
Cost of sales formula
Knowing what to include in your cost of sales calculation can be tricky. But the cost of sales formula itself is very simple:
The formula in action might look like this:
($15,000 worth of inventory at the beginning of the month + $10,000 worth of purchases for the entire month) – $11,000 worth of inventory at the end of the month
With the above formula, the cost of sales for the month comes out to $14,000.
Having an accurate and comprehensive view of how much your company spends on creating the item you sell is key to managing your finances successfully. Knowing your cost of sales will help you budget with precision, plan for growth with better visibility, and make more informed business decisions.
Cost of sales examples
Now, let’s examine some cost of sales examples with different costs and requirements.
Cost of sales example #1: Manufacturing
In this first cost of sales example, we’re adding a few more elements to the basic formula above.
A manufacturing company begins the year with $75,000 in inventory and ends the year with $55,000 in inventory. Over the year, the company purchases $15,000 worth of raw materials and spends $40,000 on direct labor. Additionally, there are some overhead manufacturing costs associated with the facilities that amounted to $20,000.
In this instance, the cost of sales formula is:
(Beginning inventory + New raw materials + Direct labor + Additional overhead) – Ending inventory
Cost of sales = ($75,000 + $15,000 + $40,000 + $20,000) – $55,000
Using the formula above, the cost of sales for the year comes to $95,000.
Cost of sales example #2: Small business
We’ll now look at a cost of sales example for a small business.
Imagine there is a small business owner who sells painted pottery. They buy the pottery from a wholesaler and then paint the pieces with their own copyrighted designs. This means that the cost of the pots, the raw materials needed to paint them, and the hours of labor will all factor into the cost of sales. But the cost of rent and utilities where the work takes place will not.
The owner wants to start paying themselves for their labor. They estimate their labor is worth roughly $1,500 per month, so they use this figure to calculate what their cost of sales would be for a month.
Cost of sales = ($2,500 + $375 + $1,500) – $1,600
In this cost of sales example, the calculation comes to $2,775. If the business owner knows the total revenue for that same period, they can then fiddle with their pay numbers in a way that benefits both their needs and their bottom line.
5 ways to reduce cost of sales
Of all the metrics in the sales and marketing world (and there are a lot of them), the cost of sales is probably the most misunderstood. Many sales managers view it as a labor cost—simply pay smaller commissions, and the cost of sales will go down.
But that’s a naive way of looking at it. Sales costs are only meaningful insofar as they affect profitability. Cutting costs in a way that cuts into revenue (a more common situation than you might expect) is wasteful and unproductive. Your goal is to make sales costs more efficient, not just smaller.
More importantly, much of a company’s sales costs are hidden inside the budgets of other groups—specifically marketing, R&D, and IT. So, you must take a broad approach to create the most efficient cost of sales.
Here are some ways to decrease your cost of sales without hurting your profitability.
Compensate on profit rather than on revenue
Many companies still use gross revenue to measure sales performance. Focusing solely on revenue, however, can put you in a position where you’re losing money on each sale and trying to make up the difference by selling a higher volume.
In the past, it was impossible to compensate on profit because back-office systems weren’t capable of reporting the profitability of each sale. But today, most businesses understand their cost of goods, which makes it possible to provide salespeople with solid estimates of how much profit their sales are generating.
Profit is the point of selling in the first place, so it only makes sense to measure sales accordingly. A big advantage of this approach is that it reduces the temptation to offer a discount (a hidden cost of sale) to close a deal.
Consider a strategic account program
Sometimes, winning and servicing a particular customer is more important than the profit generated by that customer.
For example, a small software firm might have GM as a client and tout that relationship in its marketing materials to create credibility. In this case, it may be more beneficial long-term to keep GM happy than to worry about the profit margin.
Similarly, it might make sense for a marketing services firm to lose money at the beginning of a relationship (as in a pilot project) in the hopes of winning a larger deal to provide services to an entire corporation.
The problem with “strategic accounts” is that if you have too many of them, you start hemorrhaging money. So while you should normally compensate sales reps on profit, you also need a formal process for creating an exception where a salesperson gets compensated on some other metric, like customer satisfaction or customer retention.
Use conversion rate to measure marketing efforts
Some businesses treat marketing as a strategic activity rather than a tactical one. This wreaks havoc on your cost of sales because it encourages the marketing team to measure itself based upon actions rather than sales results.
The solution is to measure marketing’s performance based on the quality of leads they generate (with quality being measured by how easily those leads convert into customers)—not on the number of brochures they print or focus groups they run.
This isn’t to say that every marketing activity should be individually measured against conversion rates. An ad, for instance, may have a cumulative effect rather than an immediate one. But the effectiveness of the marketing effort and the marketing department as a whole should be based upon lead quality. This reduces the cost of sales because it takes less time and energy to convert promising, high-quality leads into paying customers.
Create a formal process for R&D requests
There’s nothing wrong with getting R&D staff involved in a sales opportunity; indeed, some complex products require it. However, using R&D to help close deals can vastly increase the cost of sales.
Consider this: For every day an engineer spends assisting sales reps, that engineer’s current project is pushed back a day. It’s not unusual (especially in small firms) to find an entire R&D group mired in special requests from sales. This can severely delay the next version of a product.
Using R&D resources in sales situations may also encourage salespeople to sell products or product features that don’t yet exist, effectively committing R&D to do work that’s only of use to individual customers.
You can avoid these scenarios by establishing a formal process that allows sales and engineering leaders to collaboratively decide what deserves the R&D team’s attention. This will keep your employees focused and ensure your R&D costs are applied wisely.
Lower your sales-related IT expenses
Your CRM system can be a huge sales expense. This is particularly true if a CRM implementation fails, which happens about 50 percent of the time. And even if the implementation is successful, it can still be a money drainer.
The worst offenders in this area are the old ERP-based, in-house SFA systems. These clunkers not only cost big bucks in license fees but also hinder sales by forcing sales activities into outdated sales processes.
Client-server implementations can be just as bad. The culprit here, however, isn’t obsolescence so much as it is the feature-creep that’s endemic to PC-based software. Salespeople want to sell—they don’t want to fuss with complicated screens.
What’s worse, if you add a bunch of applications to a client-server CRM system, it increases the complexity and creates the huge risk that your customizations won’t work on successive versions of the platform.
In other words, you want to make sure your CRM is hassle-free. The simpler the software, the easier it is to learn and the less it will cost to implement and maintain. It’s also important to choose a CRM that can scale with your business.
Zendesk Sell is a top sales CRM thanks to its flexibility, ease of use, collection of tools, and scalability. Our customizable system delivers full pipeline visibility, tracks sales activities, generates data-driven reports, predicts revenue growth, and more. Request a demo today to learn how Zendesk Sell can improve your cost of sales and overall sales performance.