Making a million dollars in sales doesn’t mean you’re pocketing a million dollars. Learning how to compute cost of sales is what reveals your true profit. You have to subtract what it costs to make or acquire what you sell.
How much you keep comes into focus once you can account for your cost of sales. This key metric represents the direct expenses tied to providing services and producing or purchasing goods.
Below, you’ll learn how to compute cost of sales, why this critical figure impacts your bottom line, and how to reduce it.
Key takeaways
- Cost of sales captures the direct costs of producing or delivering whatever your business sells, including materials and the labor tied to each sale.
- The cost of sales formula is beginning inventory plus purchases, minus ending inventory.
- Cost of sales and cost of goods sold overlap, but cost of sales also applies to service businesses that sell no physical goods.
- Your inventory accounting method (first in, first out; last in, first out; or weighted average) changes the cost of sales figure and your gross margin.
What’s the difference between cost of sales and 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 wages belong in your cost of sales. COGS doesn’t apply when you don’t sell any physical goods.
One important thing to note is that only direct expenses are included in cost of sales and COGS figures, not indirect costs. Indirect costs support the business’s overall operation but aren’t directly tied to producing goods or providing services. Things like rent, utilities, and administrative salaries still affect your overall profitability, but they usually fall under operating expenses instead.
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.
1. 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.
The wages paid to the carpenters who craft each piece belong there too. The electricity used to power the tools and finishing touches like varnish would also count.
2. 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. Office rent, accounting services, and other general overhead wouldn’t be included.
3. Retail
Say you run an online clothing store. Your cost of sales starts with the wholesale price of the clothing you stock, plus the shipping costs from the supplier to your warehouse. It also covers any expenses tied directly to preparing items for sale, like packaging and labels.
If you hire staff to manage order fulfillment for your online store, their direct labor expenses count as part of your cost of sales too.
How to compute cost of sales using the 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. Subtract the cost of sales from your total revenue to find what’s left. That remainder is your earnings after covering the direct costs of producing goods or services.
Use this quick process to compute your cost of sales, step by step:
- Beginning inventory: The value of goods or materials in stock at the start of a period, usually the fiscal year or quarter.
- Purchases (or direct costs): Additional expenses you incur during the period, like inventory, raw materials, or supplies used 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.
Consider a quick 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.
What accounting methods can you use to calculate cost of sales?
The cost of sales formula stays the same. But the dollar value you plug in depends on how you assign cost to the inventory you sell. Three methods dominate:
- First in, first out (FIFO): Assumes your oldest inventory sells first, so early purchase costs enter cost of sales; newer stock stays on the books.
- Last in, first out (LIFO): Assumes your newest inventory sells first, so recent purchase costs enter cost of sales; older costs stay in ending inventory.
- Weighted average cost: Blends every available unit into a single average cost, then applies it to each unit sold and each unit in stock.
The method you pick isn’t just bookkeeping trivia. AccountingTools confirms the cost of goods sold formula: beginning inventory + purchases − ending inventory. The same source adds that your chosen method “has a direct bearing on the amount of expense charged to the cost of goods sold.”
That effect carries straight through to your gross margin. The IRS explains that in times of rising prices, LIFO produces a larger cost of goods sold and a lower closing inventory. FIFO does the opposite, with a lower cost of goods sold and a higher closing inventory.
Higher COGS means lower reported gross profit, and the reverse holds when COGS falls. So the same physical stock can produce different profit figures based on your method alone.
Location matters too. KPMG notes that LIFO is permitted under US Generally Accepted Accounting Principles (GAAP) but prohibited under International Financial Reporting Standards (IFRS). That prohibition sits in International Accounting Standard 2 (IAS 2), so international reporters can’t use LIFO.
Weighted average cost, by contrast, is accepted under both US GAAP and IFRS. That makes it a practical choice for businesses that report across borders.
How can you reduce your cost of sales?
You can see how a higher cost of sales eats into your profit. Reducing the direct expenses tied to your goods or services makes your business more profitable.
How do you turn that goal into a reality? These eight 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, buying 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. A ratio that drops too low signals excess inventory that ties up cash and raises holding costs.
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
Some businesses find that manufacturing, order fulfillment, or other tasks are driving up their cost of sales. In those cases, handing the work to specialized providers can 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 compute cost of sales and COGS is an important first step in improving your profitability. To decrease your inventory costs and operating expenses for good, 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 and keep you up to date on stock levels and sales.
Tracking cost of sales over time takes clean reporting, and that is often where visibility gaps appear. Fishbowl AI Insights lets you generate custom dashboards and reports in plain language, without SQL or custom report requests.
The payoff shows up in real numbers. According to a Fishbowl case study, Cascadia Motion cut its inventory costs by 18% through more accurate inventory management and procurement. Across the customer base, Fishbowl users see an 8% average increase in profit margins.
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.
Frequently asked questions about cost of sales
What’s the difference between cost of sales and cost of goods sold?
Cost of sales and cost of goods sold both measure the direct costs of what you sell, so many teams use the terms interchangeably. The practical distinction is scope: COGS suits physical-product sellers like manufacturers and retailers, while cost of sales also covers service businesses with direct labor. Either way, the figure sits above gross profit on your income statement, so it directly shapes the margin you report.
Is cost of sales an expense or an operating expense?
Cost of sales is an expense, but it is not an operating expense. It captures the direct costs of producing or delivering what you sell, such as materials and direct labor. Operating expenses are separate indirect costs, like rent and utilities, and they cut operating profit rather than the gross profit cost of sales affects.
What’s a good cost of sales to revenue ratio?
A good cost of sales to revenue ratio depends heavily on your industry, so no single benchmark fits every business. Read it through gross margin, which is revenue minus cost of sales, divided by revenue. Software firms often run low cost of sales while grocery and hardware retailers run high, so benchmark against direct competitors, not a broad average.
Which inventory accounting method should I use?
The right inventory accounting method depends on your goals, your industry, and where you file your financial statements. FIFO tends to show higher profits when prices rise, while LIFO lowers reported profit and can defer taxes in those same conditions. Many small sellers prefer weighted average for its smoothing, though you should confirm any method choice with your accountant.
Does cost of sales lower my taxes?
Yes, cost of sales lowers your taxable income because it is a deductible cost that reduces gross profit. The higher your cost of sales, the smaller the profit you are taxed on, all else equal. LIFO defers taxes only in periods of rising prices, so keep solid records, treat it as timing, and confirm the treatment with a tax professional.
Related posts
Keep learning with these related Fishbowl guides:
- How to Calculate Labor Cost in Manufacturing: Complete Guide
- Inventory Accounting: 6 Effective Strategies
- Cost of Goods Sold (COGS): How to Calculate & Explanation
- Understanding and Calculating the Beginning Inventory Formula
- How to Calculate and Manage Manufacturing Overhead Costs
- Landed cost: The hidden factor in your pricing formula
- 18 production planning KPIs that drive business success
- Work-in-Process (WIP) Inventory: Formula, Example, and Benefits