Cost of Sales, often referred to as Cost of Goods Sold (COGS) in product-based companies and Cost of Services (COS) in service-based companies, represents the direct expenses directly associated with producing or delivering a company’s goods or services. They typically include expenses such as raw materials, labor, manufacturing expenses, and any other costs that can be directly attributed to the production or delivery process.
By calculating and analyzing Cost of Sales, businesses can assess their ability to manage production costs, control operational efficiency, and set appropriate pricing strategies to achieve sustainable profitability.
What is Cost of Sales?
Cost of Sales is a financial metric that represents the direct expenses incurred by a company to produce goods or deliver services that were sold during a specific period. Depending on the industry or company preference, Cost of Sales is alternatively labeled as Cost of Revenue. Product-based companies often refer it as Cost of Goods Sold (COGS), while Service-based companies may refer to it as Cost of Services (COS).
Cost of Sales is a key component of the Income Statement. It includes the expenses directly associated with the production of goods or the delivery of services, such as raw materials, labor, manufacturing costs, and other directly attributable costs. It reflects the true cost of creating the products or services that generate revenue, and it is used in the calculation of gross profit.
Cost of Sales Definition
Cost of Sales is the measure of the direct costs associated with producing or delivering the goods or services that a company sells to generate revenue.
Cost of Sales is also known as Cost of Revenue. In product-based companies, it is often referred to as Cost of Goods Sold (COGS), while service-based companies may use the term Cost of Services (COS).
What is Included in Cost of Sales
Expenses included in Cost of Sales can vary significantly depending on the industry and the specific nature of a company’s business activities. This flexibility in determining Cost of Sales components is due to the unique cost structures and operational characteristics of different businesses
In product-based businesses, Cost of Sales or Cost of Goods Sold (COGS) includes the costs of acquiring or producing the items that the company sells. For example, for a smartphone manufacturer, COGS would encompass the cost of materials, direct labor, and manufacturing expenses required to produce each smartphone.
In service-based businesses, Cost of Sales or Cost of Services (COS) includes the costs related to providing the services offered by the company. For example, a consulting firm’s COS might include the salaries of consultants, travel expenses, and any other direct costs associated with delivering consulting services to clients.
Direct Costs: Cost of Sales includes only direct costs that are directly tied to production or service delivery. These costs are necessary to create the products or services that a company sells.
Excluded Costs: Cost of Sales does not include expenses that are not directly tied to production or service delivery. For example, Operating Expenses like administrative salaries, marketing expenses, rent for office space, and Non-operating expenses like interest expenses are not included in Cost of Sales.
Cost of Sales Formula
The formula for calculating Cost of Sales can be expressed differently for product-based companies and service-based companies.
For Product-Based Companies (Cost of Goods Sold or COGS)
Cost of Sales or COGS = Opening Inventory + Purchases and Direct Costs – Closing Inventory
Where:
Opening Inventory: The value of inventory at the beginning of the period.
Purchases and Direct Costs: The total cost of materials, labor, and other direct costs incurred during the period.
Closing Inventory: The value of inventory at the end of the period.
For Service-Based Companies (Cost of Services or COS)
Cost of Sales or COS = Direct Labor Costs + Direct Expenses
Where:
Direct Labor Costs: The total labor costs incurred directly for providing services during the period.
Direct Expenses: Other direct costs incurred for service delivery, such as materials, supplies, and other related expenses.
Cost of Sales and Operating Expenses
Cost of Sales and Operating Expenses (OpEx) are both essential components in a company’s income statement, but they serve different purposes and represent distinct categories of expenses.
The categorization of expenses into Cost of Sales or Operating Expenses (OpEx) is dependent on the industry and the nature of a company’s business activities.
As we already discussed, Cost of Sales represents the direct costs associated with producing the goods or services that a company sells during a specific period. These costs include expenses directly related to the production process, such as raw materials, labor, manufacturing supplies, and any other direct costs.
On the other hand, Operating Expenses represents the indirect costs incurred in the day-to-day operations of a business. These expenses are not directly tied to the production of goods or services but are necessary to run the company efficiently. Common examples of operating expenses include salaries and wages of non-production staff, rent, utilities, marketing, administrative costs, research and development expenses, and depreciation.
Cost of Sales is incurred when a company produces and sells goods or services. These costs are tied to the specific period in which production occurs.
Operating Expenses (OpEx) is ongoing and occurs throughout the operation of the business. These expenses are incurred regardless of the level of production or sales.
While it’s common practice to present Cost of Sales separately from Operating Expenses in the Income Statement, some companies may choose to include Cost of Sales as part of their Operating Expenses.
In some cases, especially in service-based industries, where the line between direct production costs and operating expenses is not as clear-cut as in manufacturing, the distinction between Cost of Sales and Operating Expenses may be less defined. This can lead to companies grouping these expenses together for simplicity and clarity in their financial reporting.
Cost of Sales directly relates to the production of goods or services and is considered a core expense. It reflects the costs incurred to create the products that generate revenue.
Operating Expenses (OpEx) includes various expenses associated with the day-to-day operation of the business. These expenses are necessary to support the core activities but are not directly tied to production.
How to Calculate Cost of Sales
The calculation of Cost of Sales involves summing up all the direct costs associated with producing goods or delivering services that were sold during a specific period.
Product-Based Companies (Cost of Goods Sold or COGS)
Let’s say a company’s opening inventory was $50,000, purchases and direct costs were $200,000, and closing inventory was $30,000.
Cost of Sales or Cost of Goods Sold (COGS) = Opening Inventory + Purchases and Direct Costs – Closing Inventory
COGS = $50,000 + $200,000 – $30,000
= $220,000
Service-Based Companies (Cost of Services or COS)
Let’s say a service-based company’s direct labor costs were $80,000, and direct expenses were $15,000.
Cost of Sales or Cost of Services (COS) = Direct Labor Costs + Direct Expenses
COS = $80,000 + $15,000
= $95,000
Examples of Cost of Sales
Let’s consider a fictional electronics manufacturing company that produces mobile phones, tablets, personal computers (PCs), and other electronic accessories.
Here’s a breakdown of possible expenses:
| Raw Materials | Costs of components like processors, memory, displays, batteries, and other hardware used in manufacturing the products | $1,500,000 |
| Labor Costs | Wages and benefits for workers directly involved in assembling and manufacturing the electronics | $400,000 |
| Manufacturing Overhead | Costs associated with production facilities, machinery, and equipment used in the manufacturing process | $300,000 |
| Packaging Costs | Expenses related to packaging materials used for the products | $50,000 |
| Employee Salaries | Wages and benefits for employees in various departments such as sales, marketing, research, and administration | $150,000 |
| Marketing and Advertising | Expenses for promoting the electronic products to consumers. | $200,000 |
| Distribution Costs | Expenses for shipping, logistics, and distribution of products to retailers and customers | $65,000 |
| Research and Development (R&D) | Expenses for designing and developing new electronic products or improving existing ones | $95,000 |
| Interest Expense | Payments made on loans or credit used for financing the company’s operations | $80,000 |
| Tax Expenses | Corporate income tax payments | $105,000 |
While calculation Cost of Sales, we have to consider only the direct expenses associated with producing goods, i.e., the direct costs in producing mobile phones, tablets, personal computers (PCs), and other electronic accessories.
Cost of Sales = Raw Materials + Labor Costs + Manufacturing Overhead + Packaging Costs
= $1,500,000 + $400,000 + $300,000 + $50,000
= $2,250,000
In the above example, Employee Salaries, Marketing and Advertising, Distribution Costs, and Research and Development (R&D) are Operating Expenses (Indirect Costs of Running the Business).
In the above example, Interest Expense and Tax Expenses are Non-Operating Expenses (Not Directly Related to Core Business Operations).
