What it means
An income statement separates the cost of what was sold from the cost of running the organisation that sold it. Cost of sales is the first: the costs that would not have been incurred had the sales not been made, or that are directly attributable to producing what was sold.
Revenue minus cost of sales is gross profit, and gross profit must cover everything else: selling and distribution, administration, research, finance and tax. For a business that sells goods, cost of sales is the cost of the goods themselves: for a retailer or distributor, the purchase price plus the costs of bringing the goods to their present location and condition (freight in, duties, handling), less supplier discounts and rebates; for a manufacturer, the production cost of the units sold, which includes direct materials, direct labour and an allocation of production overhead at normal capacity, as the inventory standards require.
Because goods are bought or made in one period and sold in another, cost of sales is derived from inventory: opening inventory plus purchases or production cost minus closing inventory, and inventory write-downs, count adjustments and the cost flow assumption all flow into it. For a business that sells services, cost of sales is the direct cost of delivering them.
A consultancy's cost of sales is its consultants' salaries, benefits and direct expenses; a software company's is hosting, customer support, third-party licences and implementation; a haulier's is drivers, fuel, vehicle costs and subcontracted transport; a bank's equivalent, under a different presentation, is interest expense and credit losses. The boundary between cost of sales and operating expenses is less standardised in services than in goods, and companies disclose their policy.
The distinction from operating expenses turns on directness and function. Selling costs (sales staff, marketing, advertising) are not cost of sales even though they are incurred to make sales, because they are the cost of finding buyers, not of what is sold; but outbound distribution is included by some companies and excluded by others.
Administration is excluded. Research and development is excluded except where it is directly attributable to specific contracts.
Depreciation is included where the assets are used in production or service delivery and excluded where they are administrative. Impairments of inventory are included; impairments of fixed assets usually are not.
Because of the boundary's flexibility, gross margin comparisons require adjustment. A retailer that includes store costs in cost of sales reports a lower gross margin than one that does not, with no difference in operating profit; a software company that includes implementation and support reports a lower gross margin than one that classifies them as operating expenses.
Analysts reclassify to a common basis, and a company that changes its policy must apply the change retrospectively and disclose it. Management uses cost of sales in more detail than the income statement shows: by product, service line, customer, channel and region, it is the basis of margin analysis, pricing, mix decisions and the identification of where the cost of what the business sells is rising or falling.
Its components (materials, labour, overhead, freight, subcontractors) are the levers of gross margin improvement.
In practice
Real-world examples.
Example
A software-as-a-service company reports cost of sales of hosting, support and third-party licences at 25% of revenue, giving a 75% gross margin that investors compare with peers on the same basis.
Example
A construction contractor's cost of sales is the cost of the work performed on contracts in the period, including site staff, materials, subcontractors and plant, matched to the revenue recognised on those contracts.
Example
A restaurant's cost of sales is food and beverages consumed, giving a gross margin of 70%, while kitchen and service staff are shown as operating expenses under its policy.
Think of it
“Cost of sales is what it costs to produce what you sold-the direct costs of your products.
Formula
Calculation
Cost of Sales (goods) = Opening inventory + Purchases or Cost of goods manufactured (including freight in, duties and handling, less rebates) minus Closing inventory
Cost of Sales (services) = Direct staff costs + Subcontractors + Direct materials and expenses + Directly attributable overhead and depreciation
Gross Profit = Revenue minus Cost of sales; Gross Margin = Gross profit / Revenue x 100%
Comparable gross margin = Reported gross margin adjusted for differences in the cost of sales boundary
Worked example 1, a service business. An IT consultancy with revenue of $24,000,000 defines cost of sales as: salaries and benefits of consultants and engineers ($11,800,000), subcontracted specialists ($2,100,000), project travel and expenses recharged and not recharged ($900,000), software and cloud costs used on client projects ($700,000), and depreciation of project equipment ($200,000). Cost of sales $15,700,000; gross profit $8,300,000; gross margin 34.6%. Below gross profit: sales and account management $2,400,000; marketing $600,000; management and administration $2,100,000; office and IT $1,300,000. Operating profit $1,900,000 (7.9%).
A competitor reports revenue of $30,000,000 and a gross margin of 48%. Its policy note shows that it excludes project travel and subcontractors from cost of sales (both in operating expenses) and includes only staff. Restating the first consultancy on the competitor's basis: cost of sales $12,700,000; gross margin 47.1%. Restating the competitor on the first's basis (adding its disclosed subcontractor and travel costs of $3,600,000): gross margin 36%. On a like-for-like basis the two are within two points; the reported gap of thirteen points was policy.
Utilisation effect: the consultancy's consultants are 68% billable. If utilisation rose to 74%, revenue would rise by about $2,100,000 with cost of sales unchanged (the staff are already employed), taking gross margin to 40%. In a service business the cost of sales is largely fixed in the short run, so gross margin is driven by utilisation and rates as much as by cost.
Worked example 2, a retailer's boundary. A clothing retailer reports: revenue $80,000,000; cost of goods purchased (net of rebates, including freight and duty) $44,000,000; store occupancy $8,000,000; store staff $9,000,000; distribution centre and delivery to stores $3,000,000; head office $6,000,000; marketing $4,000,000.
- Policy A (product cost only): cost of sales $44,000,000; gross margin 45.0%
- Policy B (product cost plus distribution): cost of sales $47,000,000; gross margin 41.3%
- Policy C (product cost plus distribution plus store occupancy and staff): cost of sales $64,000,000; gross margin 20.0%
Operating profit is $6,000,000 (7.5%) under all three. The retailer uses Policy B and discloses it; its main competitor uses Policy C. An analyst comparing the two restates both to Policy A.
Inventory effect: the retailer's closing inventory was written down by $600,000 for end-of-season stock; the write-down is within cost of sales, reducing gross margin by 0.75 points. Its stock count found a $150,000 shortage (shrinkage), also within cost of sales. Its rebates from suppliers, $1,200,000, reduce cost of sales; had it credited them to other income, gross margin would have been 1.5 points lower with no change in operating profit.Case study
Seen in the real world.
A private engineering services company prepared for sale with accounts showing a gross margin of 52%, and its owners expected a valuation reflecting a high-margin business. The buyer's due diligence reclassified the cost of sales: the company had excluded from it the salaries of project managers and engineers working on client sites (classified as staff costs in operating expenses), subcontracted labour (classified as purchases), and site equipment hire (classified as overheads). On the buyer's standard basis, cost of sales was $17,000,000 rather than $9,600,000 on revenue of $20,000,000, and gross margin was 15%, not 52%.
Operating profit was unaffected, and the buyer's valuation, based on EBITDA, did not change; but the negotiation changed, because the owners had presented the business as a high-margin professional firm and the buyer priced it as a contracting business with thin margins on delivery and modest overheads. The buyer's report noted that nothing in the accounts had been wrong, that the policy had been consistently applied and disclosed, and that the owners had believed their own gross margin for a decade because nobody had asked what was in it.
Watch out
Common mistakes.
- Comparing gross margins between companies without reconciling their cost of sales policies, which can differ by twenty points or more for similar businesses.
- Managing operating expenses in detail while the cost of sales ratio drifts, when a single point of gross margin often exceeds the whole of any operating expense line.
- Treating cost of sales in a service business as variable, when it is largely the fixed cost of employed staff and margin depends on utilisation and rates.
Questions
People also ask.
What is the difference between cost of sales and cost of goods sold?
They are the same measure under different names: cost of goods sold is the US term for product businesses; cost of sales is the IFRS term and extends naturally to services. Some companies use both.
What should a service business include in cost of sales?
The direct costs of delivering the service: billable staff, subcontractors, direct materials and expenses, hosting or delivery infrastructure, and directly attributable depreciation. The policy is a choice within the standards and must be disclosed and applied consistently.
Are supplier rebates part of cost of sales?
Rebates that reduce the cost of goods purchased are deducted from cost of sales under IFRS and US GAAP. Crediting them elsewhere overstates gross margin, and the treatment is disclosed.
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