How to calculate cost of sales for your business
In the world of business, understanding your financial metrics is crucial for success. One of the key figures you need to grasp is the cost of sales. This article will guide you through what cost of sales is, the cost of sales formula, and why understanding the cost of sales calculation matters for your business.
What is cost of sales
Cost of sales, sometimes referred to as cost of goods sold, represents the direct costs traceable to the revenue generating activities of the company. This includes expenses like materials, labour, and overheads directly tied to the manufacturing process. The cost of sales items will depend on the type of business:
- Service provider: cost of employee services it supplies.
- Retailer: cost of buying and acquiring goods which are sold to customers.
- Manufacturer: cost of buying raw materials and manufacturing of final product.
Understanding cost of sales helps businesses determine the price to charge for their products or services and can help to assess the sales required to operate profitably.
Some industries will have a higher cost of sales due to the nature of the industry they operate in. However, understanding cost of sales can help any business identify cost saving opportunities to help with the performance of the business.
How to calculate cost of sales
Calculating the cost of sales is straightforward but will include different components depending on the nature of the business. The accounting policy that a company adopts will also impact how to compute the cost of sales.
Here’s a simple cost formula for a technology service provider:
Cost of sales = cost of time spent on providing all services – time spent on all services not yet sold
The cost of time spent for a technology service provider are likely to include salaries, subcontractor cost, social security contributions, staff benefits and software used in the delivery of the services.
For example, RLL Limited provides technology consultancy services to government agencies. The company had the following costs in the year to 30 September 2024:
- Consultant salaries £250,000
- Social security and benefits costs £50,000
- Consultancy software £100,000
RLL staff worked for 1,000 hours during the year but 200 of those hours worked were spent on delivering services not yet sold to customers.
The cost of time spent on all services is £400 per hour (£250,000 + £50,000 + £100,000)/1,000).
The cost of time spent on services not yet sold is £80,000 (£400 x 200).
RLL’s cost of sales for the year = £320,000 (£400,000-£80,000)
How to compute cost of sales accurately
To compute cost of sales accurately follow these steps:
Gather stock/WIP data: Collect data on your beginning and ending stock/WIP values.
Record purchases: Keep track of all purchases made during the accounting period.
Apply the appropriate formula: Use the formula provided above to compute your cost of sales. The above formula will need to be modified if you are selling physical items.
How to determine cost of sales
Determining cost of sales involves more than just calculations; it requires a clear understanding of your business operations. Here are some tips:
Regular stock/WIP audits: Conduct regular checks to ensure your stock/WIP records are accurate.
Use accounting software: Leverage tools that can automate stock tracking and cost of sales calculations.
Analyse trends: Look at historical data to identify trends in your cost of sales, which can help in forecasting and budgeting.
How to find cost of sales
Finding your historical cost of sales can be done through your accounting records. Here’s how:
Review financial statements: Look at your income statement where cost of sales is typically listed.
Consult your Accountant: If you’re unsure, your Accountant can provide insights and help you find accurate figures.
Use stock management systems: These systems often have built-in features to calculate cost of sales automatically.
Conclusion
Understanding and calculating the cost of sales is essential for any business owner. It not only helps in assessing profitability but also aids in making strategic decisions regarding pricing and inventory management. By following the steps outlined in this article, you can ensure that you have a clear picture of your business's financial health.
If you have any questions or need further clarification on any of these points, feel free to ask us at Tech Relief!
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