Running a successful business means keeping tabs on a variety of important metrics, including your cost of sales. But what is cost of sales? Cost of sales includes the direct costs of producing your goods or delivering services, and It’s a critical metric for growing your small business.
Having an accurate picture of your cost of sales will show if you’re selling viable products or services and if they’re priced correctly. Fixing operating expenses can be done quickly but fixing your cost of sales means taking a hard look at your business model.
Let’s dive into the details of cost of sales so you can get the most out of this business metric.
What is gross profit?
Before understanding your cost of sales, it’s important to understand gross profit. Gross profit is the money you make on sales after accounting for the cost of sales. The equation is:
Gross profit = Revenue – Cost of sales
Your gross profit margin is similar to your overall markup. For example, if you’re selling your products at a 3x markup, you would see a gross profit margin of 66%. If you’re selling your services at a 60% markup you would see a 37.5% gross profit margin. That’s an important figure to know because it shows the demand for what you’re selling.
The amount your customers are willing to pay for your offerings is directly connected to their perception of quality and value. That’s why it’s difficult to improve your gross profit margin. Changing your pricing without changing the quality (and your cost) could impact your demand or reduce your profit.
Gross profit is important, but it begs the question: what are your real costs? This is where your cost of sales comes in.
What is cost of sales?
Cost of sales is a key profitability metric that includes the direct costs of producing your goods or delivering services. This helps you distinguish the expenses that drive revenue from the expenses required to run the business overall.
While cost of goods sold (COGS) and cost of sales both track the cost of producing a good or service, COGS is a narrower concept. COGS is typically used by businesses that sell physical products and inventory-related costs, and cost of sales is a broader concept, making it relevant for all types of businesses.
By tracking the cost of sales, your business can gain a more realistic view of gross profit and can make better-informed decisions about pricing, growth, and operational efficiency.
How to calculate your cost of sales
The equation for the cost of sales is:
Cost of sales = Direct labor + Direct materials + Manufacturing overhead
It’s easier to determine whether your business buys products from a supplier and sells them at a markup. If your business makes its products in-house, or if you sell your labor by the hour, it’s more complex to calculate cost of sales. Here’s the information you’ll need to determine your true cost of sales:
- Direct labor: This is the labor that goes directly into making your products or into paying your employees for providing services to your customers. Businesses in the construction and professional services industries tend to have more costs for direct labor.
- Direct materials: This is the cost of inventory that you buy to resell to customers. It’s also the cost of the materials you use to make the products you sell.
- Manufacturing overhead: These are costs that are traditionally categorized as overhead expenses, but it only includes the costs related to the process of making your products or providing your services. You’ll need to determine if it makes more sense to count these costs as part of your gross margin rather than general overhead.
How to determine direct labor and applied costs
It’s tricky to determine an accurate amount of direct labor for your business. Many of your employees may be involved in sales or administration and not have anything to do with “direct labor.” Or some of your “direct labor” employees might spend some of their time completing administrative tasks.
Here are the steps to get the most accurate number possible:
- You’ll need to gather data on your projects and track employee hours more effectively. You can start by using one of the many time-tracking software products available, such as Quickbooks Time. This data will also help you improve your pricing.
- Once you gather data on the number of hours of employee time spent on each project, calculate an average.
- Use the average calculation to “apply” your wages to your direct labor costs.
When you track “applied wages,” that means you’re tracking all your wages in one category, like in general operating expenses. You’re then shifting some of the wage costs into your cost of sales based on the average metric you calculated.
For example, your business uses an average of 10 hours of labor per project. This month you complete three projects and your business pays a total of 100 hours of labor. In this situation, you would shift 30 hours of labor cost from operating expenses into direct labor.
Similar to direct labor, your costs for materials can be applied to cost of sales. You’ll need to gather data on the number of products made over time and the amount of materials used. Then you’ll determine an average per product. You can “apply” your materials cost by taking a similar amount out of inventory and applying it to your cost of goods sold.
How accounting methods affect your cost of sales
After gathering the information you need on direct materials, direct labor, and manufacturing overhead, you’ll start to see a bigger picture of your cost of sales. Now, you’ll need to consider your accounting methods. The methods you use can have an impact on the cost of sales for your business.
There are a few accounting principles you should know as a business owner, including the difference between cash-basis and accrual-basis accounting:
- Accrual-basis accounting: This method properly matches the timing of these costs to the timing of when you receive your revenue. Using accrual-basis accounting will give you the clearest picture of your cost of sales at any point in time.
- Cash-basis accounting: This method will create financial statements that show wildly different gross profits from one period to the next. In months that you provide your services and make products, you’ll show overly high costs. And then in months that you get paid for your products and services you’ll show overly high profits.
Knowing your costs will help your business grow
Now that you can accurately calculate your cost of sales, you’ve got intel on what your real costs are for your business. Use this information to make decisions on changes to your business model, or find new opportunities to expand and grow.
If you need financing to make your new plans a reality, talk to Pursuit! With over 70 years of lending experience and more than 15 different business loan programs available, we can help you get the capital you need to reach higher.
Reach out to us today!
