What is cost of sales in a small business?

Understanding how money moves in and out of your business (your cash flow) is essential to staying on top of your company’s financial health. Cost of sales is an important part of your cash flow and one of the key aspects you need to keep track of.

This guide will help you understand cost of sales by exploring:

• What cost of sales is
• What to include in your cost of sales calculation
• How to calculate your cost of sales
• What else you need to know about cost of sales
• How to manage your costs easily with Countingup

Also referred to as the cost of goods sold (COGS), cost of sales refers to the direct costs related to manufacturing the products or services you sell to your customers. Cost of sales focuses only on these expenses, ignoring the selling, general and administrative (SG&A) expenses and interest expenses (charges for borrowing money). 

In short, cost of sales tracks your ability to produce or deliver goods and services at a reasonable cost.

A point where people often get stuck when it comes to the cost of sales calculation is what expenses they need to include. It’s like this:

If you could still manufacture your product or deliver your service without paying for a certain expense, then you leave that expense out of your calculation. However, if you fail to pay a cost and your entire production stops because of it, you’ll need to include it. 

Some expenses you may need to include are:

• Software licensing
• Raw materials or supplies needed for production
• Cost of packaging for products
• Cost of storing products or materials

Essential costs vary depending on your business and the sort of products you make. Still, we’ve listed a few items that don’t directly link to production, meaning you shouldn’t include them in your calculations. For example:

• Customer success costs (helping customers achieve their goals with the product or service)
• Costs related to upselling (encouraging customers to buy a better, more expensive product/service)
• Cost of specific overheads (ongoing operational expenses)
• Cost of product development (creating a new product or improving an existing one for customers)

Aside from these costs, there are two key factors to consider when calculating your costs of sales, which are as follows:

Your beginning inventory refers to products you have when you start a new accounting period,  usually at the beginning of a new tax year. This inventory is a cash amount that matches what that inventory is worth.  

You need to include purchases, including the new products you produce or buy to add to your inventory throughout the year.

Beginning inventory covers several items, including:

• Inventory left over from the previous year (products that didn’t sell)
• Raw materials used to make the products
• Related supplies (packaging, etc.)

How do you establish a starting point for your cost of sales calculation? First, you’ll need the value of your beginning inventory for that accounting period. Use your accounting records (where you log and track your financial transactions) to calculate this number and include it in your beginning inventory calculation.

On the other side of the equation, your ending inventory is the total value of products you have in stock at the end of the accounting period. You typically determine this number by taking a physical count of your inventory.

While it may seem complicated, calculating your cost of sales is relatively straightforward. There’s a simple formula you can use:

Cost of Sales = Beginning Inventory + Purchases – Ending Inventory

How does this formula work in practice?

Let’s say a company has £5,000 worth of inventory at the beginning of the month and spent £1,000 on raw materials and delivery. If that same company has an ending inventory of £3,000, you use that to calculate the cost of sales for that month:

Cost of Sales = £5,000 + £1,000 – £3,000 = £3,000

This means that the total cost of sales for that month was £3,000.

Now that you understand what cost of sales is and how to calculate it, we’d like to cover a few aspects to consider when it comes to cost of sales in general. 

Firstly, you only need to track cost of sales if you sell physical products, such as clothing, baked goods or accessories. If you run a service-based business and don’t carry inventory, you don’t need to track cost of sales. Examples of service-based jobs could be personal trainers, contractors, tutors or engineers.

Additionally, if your business hasn’t made any sales during a specific time period, you can’t deduct money from your cost of sales. This applies even when you’ve manufactured or bought products to sell.

Don’t forget to factor in facility costs when valuing the cost of your inventory. Facility costs refer to expenses relating to the facility (building) where you make your products, including rent and utility bills. It’s important to account for these costs to make sure your ROI (return on investment) is positive, meaning you make enough money selling your goods for the cost to be worth it.

As your business grows, cost of sales calculations can be challenging to handle. You may want to consult with an accountant or bookkeeper to double-check your calculations or have them calculate them for you.

The Countingup business current account makes it simpler to manage your business finances. The app comes with free built-in accounting software that automates the time-consuming aspects of bookkeeping and taxes. You can access real-time insights into your business’ finances, profit and loss reports, tax estimates and invoices. 

You can also share your bookkeeping with your accountant instantly without worrying about duplication errors, data lags or inaccuracies. Seamless, simple, and straightforward!

Download the Countingup app to apply for your business current account in minutes. All you need is proof of ID and a selfie. Find out more here.