The cost of sales measures the direct expenses associated with producing a product or service, such as raw materials, packaging and storage. It doesn’t include selling, general and administrative expenses (SG&A), such as marketing and office rent, as these aren’t directly linked to making your goods.
Cost of sales is a key metric used to calculate gross profit margin, which shows you the amount of revenue left after covering the costs of producing your goods. “With precise knowledge of your cost of sales and gross profit margin, you can make informed decisions about pricing, special offers and discounts,” says Tom Mercer, Director at Bean Ninjas Europe. “This also helps you determine the number of units you need to sell to cover all other business expenses.”
What is the cost of sales formula?
The cost of sales formula takes the value of your inventory at the beginning of a specified period, such as at the start of a year, and subtracts the value of your inventory at the end of that period. It also accounts for any new inventory purchased in the period. When you have these numbers, the cost of sales formula is as follows:
Cost of Sales = (Beginning Inventory + New Inventory) - Ending Inventory
It’s important to remember that inventory refers to all the costs associated with the production and delivery of your goods or services, and not just the value of the goods themselves. This means it includes both the cost of raw materials and the costs of turning raw materials into products or services, such as storage, packaging and delivery to customers or clients.
Different businesses classify different costs in different ways, notes Tim Rylatt, Managing Director at UK Growth Coach, a business coaching organisation. “The important point is to understand which costs are related directly to each job and to be consistent in how they are recorded, monitored and reviewed across different projects and working areas.”
Understanding your cost of sales can be especially valuable during cash flow challenges, says Mercer, by helping you to identify which products offer the highest return. However, maintaining consistency in cash flow year-round can be tough. The American Express® Business Gold Card can give business owners more flexibility and control in managing business costs and expenses with extended payment terms of up to 54 days, the money stays in your account for longer¹.
7 methods to lower cost of sales
1. Analyse and monitor costs
Monitoring your cost of sales regularly will allow you to quickly identify and address any issues before they escalate. Rylatt recommends calculating the cost of sales when determining the price of any product or service-based project for a customer, and when reviewing its profitability against expectations.
“At a strategic level, a periodic review to [assess if and] where the cost of sales are proportionally higher than expected across a whole division or business is wise,” says Rylatt. “This can flag the effect of factors such as inflation and changes in global supply chain costs.”
As part of this, Mercer adds that it's important to monitor shipping costs, as it can sometimes be cheaper to organise shipping yourself rather than through your suppliers.
2. Control your direct costs
Tracking the costs associated with the production and delivery of your products or services is essential for keeping your cost of sales to a minimum. These include raw materials, storage, packaging and shipping. Keeping a close eye on these costs means you can quickly identify areas of waste and inefficiency, and then swiftly take measures to control them.
For any employees directly involved in the production of your goods, Rylatt suggests using time tracking. This will show you where time is being allocated, so you can identify areas for improvement. It may be, for example, that there are repetitive tasks that could be automated using technology, freeing up staff time to allocate elsewhere.
3. Create standard operating procedures
Mercer recommends creating standard operating procedures (SOP), combined with regular training and improvement, to improve consistency and efficiency and to reduce errors. A SOP is a set of detailed instructions that guides your employees on the specific activities and processes required to complete certain tasks. Having well-defined SOPs can reduce areas of waste.
4. Enhance supplier relationships
“If you maintain a good relationship with suppliers, they may be more susceptible to pricing negotiations,” shares Mercer. When you have a strong relationship, you’re in a better position to negotiate. These could be in the form of an upfront discount for bulk purchases or a rebate for selling a certain number of items, Mercer notes.
5. Constantly review your suppliers
While it’s important to nurture strong relationships with your suppliers, it’s also important to review your suppliers regularly to ensure you’re getting the best deal. “Be open to new markets, especially now with the increased shipping costs,” notes Mercer. It may be for example that using a local supplier is more competitive than transporting goods from further away, he adds.
6. Analyse trends to plan ahead
Use data to analyse historic business trends and use this to plan your inventory and production. This may include making sure you have enough stock to fulfil periods of high demand or enough resources to fulfil expensive last-minute orders, notes Mercer.
7. Optimise pricing strategies
“Don’t hesitate to cut products that have a high cost of sales, unless they are used as a hook product,” Mercer says. Hook products are designed to attract new customers to your company, in the hope they buy other, higher-margin products. Alongside this, don’t be afraid to move out of markets where the cost of sales is too high.
Mercer shares an example. “We had a client based in the UK who started selling in Germany,” he says “On first look, it seemed that business was going well as sales were respectable, but then when the cost of sales was calculated it was found to be just breaking even, so with all the extra work involved in selling in Germany, it was decided to exit this market and focus on the core UK business.”
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
