Understanding the Significance of Cost of Sales or Cost of Goods Sold (COGS).
Cost of Sales (also referred to as Cost of Goods Sold [COGS]) is a very important financial performance metric, as it tracks your ability to manufacture/deliver goods and services at a reasonable cost. It represents the direct costs related to the manufacturing of goods/services that are sold to your customers during a specific period. These costs typically include expenses such as raw materials, labour, and manufacturing overheads directly related to production.
Tracking Cost of Sales is crucial for businesses as it directly impacts profitability, reflects operational efficiency, and informs pricing strategies. This metric is a key component of the income statement, providing insights into the direct costs associated with generating revenue. The specific items included in the Cost of Sales section vary depending on the industry in which you operate.
What should be included in your Cost of Sales/ COGS?
Business owners often get stuck on what should be included in their cost of sales.
A simple way to break this down is outlined below:
- If you stopped paying for a certain expense, could you continue to manufacture the goods or deliver your services?
If the answer is Yes – this item should not be included in cost of sales.
- If you failed to pay for a specific expense would this cause production/delivery of services to grind to a halt?
If the answer is Yes ā this item should be included in your cost of sales.
Industry-Specific Cost of Sales Insights
To get a real understanding of your margins, in this downloadable flyer we share which expenses you should include in your Cost of Sales specific to the following industries:
- Professional Services (legal, finance, real estate, architects, etc.)
- Hospitality
- Medical
- Construction
- Transport
- Manufacturing
Click on the images below to expand:
Need to add any expense items to your Cost of Sales? ā
If you want to allocate any of your expenses to a Cost of Sales item, changes can be made in the chart of accounts in your datafile.
How to calculate COGS or Cost of Sales
The Cost of Sales formula:
Beginning Inventory + Purchases During the Period – Ending Inventory = $COS figure
Letās consider a simplified example for a construction company to calculate COGS:
Suppose a construction company is building a residential house. Here are the costs involved:
Beginning Inventory: At the start of the month, the company has $20,000 worth of construction materials, such as timber, bricks, and cement, in its inventory.
Purchases During the Month: Throughout the month, the company purchases additional materials totalling $10,000 to continue construction.
Labor Costs: In addition to materials, the company incurs $15,000 in labour costs for the month, including wages for construction workers and subcontractors.
Other Direct Costs: The company also spends $5,000 on other direct costs, such as equipment rentals, permits, and insurance related specifically to the project.
Ending Inventory: At the end of the month, after accounting for the construction progress, the company has $12,000 worth of materials remaining in its inventory.
Now, letās calculate COGS using the formula:
COGS = Beginning Inventory + Purchases During the Month + Labor Costs + Other Direct Costs ā Ending Inventory
= $20,000 (Beginning Inventory) + $10,000 (Purchases) + $15,000 (Labor Costs) + $5,000 (Other Direct Costs) ā $12,000 (Ending Inventory)
= $48,000
So, the COGS for the construction project during the month is $48,000. This represents the direct costs associated with producing the construction work completed during the period.
By calculating COGS, the construction company can assess the direct expenses incurred for the project, track profitability, and make informed decisions to optimise costs and improve financial performance.
Why is Cost of Sales so important?
Whilst calculating the Cost of Sales is relatively simple, knowing this number will help to assess how effectively you are managing the manufacturing/service delivery process and help you ascertain the business’s overall gross profit margin.
The cost of sales formula is vital in understanding your business’s financial performance in greater depth.
How can Walsh Accountants help?
Understanding how to calculate the cost of sales is so important as it gives you the information you need to stay on top of your business’s financial health.
If you don’t understand the internal movement of your capital, cash flow becomes extremely difficult to manage.
The team at Walsh Accountants can play a vital role in analysing your business’s COS data, calculating gross profit margin, and providing strategic advice to optimise cost management. By accurately assessing COS, your business will be able to identify areas for improvement, make informed decisions, and drive sustainable growth.
Contact our office for a confidential discussion based on your personal circumstances.
