Running a successful business means keeping tabs on a variety of important metrics. One measure you might be familiar with is “cost of goods sold” or COGS. But COGS is just one part of a broader category called “cost of sales.” What is cost of sales? 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 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.
The importance of gross profit
Before understanding your cost of sales, it’s important to know about gross profit. Gross profit is the money you’re making on each sale minus the 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.
Calculating your full cost of sales
Cost of sales is easier to determine if your business buys its products from a supplier and sells them for 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 what 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: This category is often overlooked by business owners. 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.
Handling direct labor and applied costs
It’s tricky to determine an accurate amount of direct labor for your business. Many of your employees might 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.
To have the most accurate number possible, you’ll need to gather some data on your projects and track employee hours in a more effective way. You can start by using one of the many time-tracking software products available, such as HiveDesk and Quickbooks Time, if you’re not already. This data will also help you improve your pricing.
Once you gather data on how many hours of employee time went into each project, calculate an average. Use that figure 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.
Let’s look at an example. Say that your business uses an average of 10 hours of labor per project. This month you completed three projects and your business paid a total of 100 hours of labor. In this situation, you would shift 30 hours of labor cost from operating expenses into direct labor.
Like direct labor, your costs for materials can be applied to cost of sales in the same way. 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 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 figure 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. It’s best to use accrual-basis accounting when you’re calculating your cost of sales. This method properly matches the timing of these costs to the timing of when you receive your revenue.
If you use cash-basis accounting, you’ll end up with 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.
Using accrual-basis accounting will give you the clearest picture of your cost of sales at any point in time.
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 more than 15 different business loan programs available, we can help you get the capital you need to reach higher.