Cost of Sales: Definition, Formula, and Examples
Learn the definition of cost of sales and how it is used to capture key production expenses.
What is Cost of Sales?
A company’s cost of sales refers to the costs related to producing a good or service. The cost of sales will include direct labor costs, direct materials costs, and any production-related overhead costs. The cost of sales is located near the top of a company’s income statement and is also sometimes referred to as the cost of goods sold (COGS).
Example direct labor costs:
- Wages for manufacturing assembly line employees (manufacturing companies)
- Wages for staff performing direct service (service businesses)
- Sales commission for sales staff (service businesses)
Example direct materials costs:
- Rubber used to make car tires
- Plastic used to make sunglasses
- Steel used to make bicycle parts
Example production overhead costs:
- Rent for factory or production facility
- Insurance cost for production facility and equipment
- Wages for maintenance workers and other supporting production workers
Cost of Sales Formula (Manufacturing Businesses)
Cost of Sales = Beginning Inventory + Purchases - Ending Inventory
A manufacturing company will track its inventory in the current assets section of its balance sheet. Once inventory is sold, the revenue collected from the inventory sale and the cost associated with producing the inventory is recognized as revenue and cost of goods sold or cost of sales on the income statement.
Cost of Sales Formula Inputs:
- Beginning inventory: Value of inventory from the start of the year (end of last year).
- Purchases: Expenses required to produce additional inventory in the period.
- Ending inventory: Value of inventory at the end of the year.
By tracking the change in inventory, the manufacturing business can correctly allocate the amount of production costs associated with the goods sold in the period. The production costs associated with goods manufactured but not yet sold are not recognized as an expense on the income statement until the goods are sold.
Cost of Sales Formula (Service Businesses)
Cost of Sales = Value of time spent on all projects - Value of time spent on incomplete (work-in-progress) projects
A service business will typically not have the traditional product inventory found in a manufacturing or retail company. However, longer-term service projects that are not yet complete can be treated as “inventory” or really a service not yet delivered to the customer.
With this in mind, you can use similar “inventory” tracking logic to deduct the value of time spent on incomplete projects from the value of the total time spent on projects in the period to calculate the cost of sales associated with the services delivered in the period.
Example Cost of Sales (Manufacturing Company)
Assume SnowTown T-Shirt company has $8,000 worth of unsold t-shirts leftover from the end of last year. The clothing company then spends another $80,000 in direct labor, direct materials, and manufacturing overhead to produce more t-shirts during the year. At the end of the current year, the company is left with $10,000 worth of unsold t-shirts.
What was its cost of sales during the period?
- Beginning inventory = $8,000
- Purchases = $100,000
- Ending inventory = $10,000
- Cost of sales = $8,000 + $100,000 - $10,000 = $98,000
Example Cost of Sales (Service Business)
Assume JTB Consultants paid its consulting team $60 per hour for spending 5,000 hours working on projects for consulting clients in the current year. In the last month of this year, the team spent 100 hours on a project that won’t be completed until the following year.
What was its cost of sales during the period?
- Total value of time spent = $60 * 5,000 hours = $300,000
- Total value of time spent on incomplete projects = $60 * 100 = $6,000
- Cost of sales = $300,000 - $6,000 = $294,000
Real Company Example: Nike Cost of Sales
Nike, the giant footwear and apparel brand, is an example publicly traded company that uses the cost of sales in its financial statements posted on its annual 10-K report.
Although the company isn’t required to show its exact cost of sales inventory calculations, you can often review the ending inventory amounts for each year by finding them on the company balance sheet. You’ll also often find additional notes within the annual report describing the additional cost details of expenses grouped into the company’s cost of sales.
Example Nike cost of sales note:
Cost of Sales vs Cost of Goods Sold
Retailers and service-oriented businesses like lawyers, consultants, and doctors tend to use the term cost of sales or cost of services. Manufacturing companies on the other hand tend to use the term cost of goods sold as this label better fits the expenses tied to making a tangible product. Fundamentally, both terms are interchangeable and capture any costs linked to producing a product or service.
Why is Cost of Sales Important?
The cost of sales line item on a company’s income statement allows investors to have a first look at the profitability of the production process. The cost of sales (or sometimes cost of good sold) is deducted from a company’s revenue to arrive at the company’s gross profit.
Financial analysts will often look at the gross profit and gross margin percentage (gross profit divided by revenue) to measure how profitable a business is before looking at general operating expenses, interest expenses, and taxes. Different industries will often have different average profit margin standards as a manufacturing company will likely incur a high amount of direct production costs while a service-oriented company will likely have very small amounts of direct production costs.
Cost of Sales vs Operating Expenses
Cost of sales is different from operating expenses in that the cost of sales covers costs directly tied to the production of goods and services. General operating expenses capture costs not directly tied to the production of goods or services but are still needed to keep the company running.
Example operating expenses:
- SG&A (Selling, General, and Administrative Expenses): Overhead costs not directly linked to production.
- Rent: Office space, Warehouse space to store finished goods. Rent for a factory or production facility would be considered a cost of sales expenses.
- Utilities: All utility expenses not directly tied to production.
- Sales & Marketing: advertising costs, base wages for sales and marketing personnel (excluding sales commissions).
- R&D (Research & Development): Testing expenses for future product improvements.
Cost of Revenue vs Cost of Sales
A company’s cost of revenue is similar, but not exactly the same as the company’s cost of sales or cost of goods sold. The cost of revenue includes the total cost of producing the product or service as well as any distribution and marketing costs. Some companies will use cost of sales or cost of goods sold while other companies will use cost of revenue. This choice may shift certain expenses to and from the operating expenses section of a company's income statement.
Example cost of revenue expenses:
- Cost of sales
- Shipping costs
- Commissions
- Warranties
- Returns
- Discounts
- Other direct costs
Additional Resources
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