What Does the Term “Cost of Sales” Mean in Accounting
When you don’t know how money goes around your company, managing cash flow can be difficult. Cost of sales is one of the most important KPIs to track for this task (particularly when selling real goods).
It doesn’t have to be difficult to keep your finger on the pulse of your financial data. We’ll go through what cost of sales is and how to calculate it in this article.
What does Cost of Sales mean?
Cost of sales, also known as cost of goods sold (COGS), is the overall cost of manufacturing, creating, and selling a product. As a result, only organisations who keep physical inventory need to keep track of this metric on a regular basis.
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While the definition of cost of sales is simple, calculating it might be difficult depending on the things you sell. The cost of sales formula incorporates a number of direct and indirect factors that might make the computation more difficult.
Cost of sales must be included as an expense on income statements because it is deemed a “necessary item” to keep your firm going. To calculate your company’s gross profit and gross margin, you’ll also require cost of sales.
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Is the cost of items sold and the cost of sales the same?
Yes, the cost of goods sold and the cost of sales are the same computation. Both determine how much a corporation spent on the goods or services it sells.
How do you figure out the cost of goods sold?
The COGS consists of the following:
- Materials used in the production of a product or the provision of a service
- the amount of labour required to create a product or provide a service
- Overhead costs are costs that are directly tied to production (for example, the cost of electricity to run an assembly line)
The COGS does not include:
- Expenses incurred indirectly (for example, distribution or marketing)
- Expenses incurred as a result of general business operations.
- The price of producing unsold goods or services.
How can you calculate the cost of goods sold?
COGS is calculated by multiplying the cost of inventory at the start of the year by the cost of purchases made during the year. Then deduct the cost of residual inventory at the end of the year. The final figure will be your company’s annual COGS.
Calculating COGS typically aids in determining how much tax you owe at the conclusion of the reporting period, which is usually 12 months. You can calculate your annual profits by deducting your annual cost of sales from your annual revenue. COGS can also aid in the calculation of corporate assets by determining the worth of your inventory.
Methods for calculating inventory costs
Businesses who create, buy, or sell products for profit are required by the HRMC to assess the cost of their inventory. HMRC may require a certain inventory costing method depending on the size of the business, kind of business licence, and inventory valuation. However, once a company has decided on a costing strategy, it should stick to it year after year. Consistency aids companies in adhering to generally accepted accounting principles (GAAP).
The weighted average costing approach can be used if an item’s cost is easily identified. However, some expenses may be difficult to identify or too deeply entwined, such as when creating large batches of things. The HMRC recommends either FIFO or LIFO costing methodologies in certain situations.First in, first out (FIFO)
The costing approach of first in, first out (FIFO) presupposes two things:
- The first products acquired or manufactured were also the first to be sold.
- The expenses of comparable products recently purchased or produced are matched with the inventory items at the conclusion of your reporting period.
Due to market value or availability, the price of products frequently swings over time. Prices rise over time as a result of inflation. Prices fall over time as a result of deflation. Depending on how those prices affect a company, it may opt for an inventory costing approach that best suits its needs.
The FIFO technique posits that a company’s least expensive products sell first during inflation. As prices rise, the company’s net profit may rise as well. When compared to the LIFO technique, this process may result in a reduced cost of goods sold. During a period of price deflation, however, the opposite may occur.Last in, first out (LIFO)
The LIFO (last in, first out) costing approach is based on two assumptions:
- The first products sold are those that were purchased or manufactured latest.
- Items in closing inventory are regarded to be part of the same year’s opening inventory. Items are assumed to have been sold in the order in which they were acquired. This includes both products that were in your inventory at the start of the year and those that were acquired throughout the year.
During periods of inflation, the LIFO approach will have the opposite effect as FIFO. Because inflation causes prices to rise over time, the most recent products manufactured cost more than the most recent items made. The LIFO technique posits that higher-cost items (those manufactured last) will sell first. As a result, the company’s cost of goods sold will be greater because the products are more expensive to produce. LIFO assumes a reduced profit margin on sold items as well as a lower inventory net income. The converse can happen during times of deflation.
Cost of goods in a service companies
COGS may be recorded by some service providers as part of their offerings. Other service businesses, frequently referred to as pure service businesses, will not keep track of COGS at all. The difference is that some service businesses do not have any products to sell or inventory.
The following are some examples of service organisations that have inventory:
- Electrical and plumbing
- Installation and repair
- Manufacturing and mining
- Transportation and lodging are included.
A plumber, for example, may provide plumbing services as well as stock inventory to sell, such as spare parts or pipes. To calculate COGS, the plumber must add the cost of labour as well as the cost of each component used in the service.
Consider a bed and breakfast inn. Although the business’s principal service does not necessitate the selling of commodities, it may nonetheless sell merchandise such as food, toiletries, or souvenirs.
The following are some examples of pure service businesses that do not have inventory:
- Firms that provide accounting services
- Lawyers’ offices
- Firms or appraisers of real estate
- Consultants in business
What is the significance of calculating the cost of sales?
You must know how to calculate and comprehend your cost of sales if you want to manage your business’s profitability and increase your bottom-line profit.
You must first evaluate the costs in order to calculate gross profit in your organisation.
Any business’s costs are divided into two categories: sales costs and overhead charges.
It’s critical to distinguish between the two in order to determine your company’s genuine profitability.
If you get the cost of sales correct, your business’s overheads should be essentially consistent, allowing the cost of sales to rise and fall in tandem with the company’s sales.
The cost of sale for a retail business that sells products is the item itself, which includes the cost of getting it from your supplier to you as well as any charges (such as running expenses, administrative costs, and direct labour costs) that make it sellable.
This would comprise raw supplies, manufacturing time, and other related production costs for a manufacturing company.
You’ll be able to tell whether your business is improving or not if you can track your cost of sales consistently. You can make decisions to increase your business’s profit by having clarity on what makes you money and what doesn’t.
The importance of COGS to your business
COGS can assist you calculate your net revenue, expenses, and inventory by calculating and tracking them throughout the year. When tax season arrives, keeping accurate COGS records will assist you and your accountant in properly filing your taxes. Calculating the cost of goods sold is just one aspect of your company’s operations. Understanding COGS, on the other hand, might help you better comprehend the financial health of your company.
We hope you found this article to be informative.