As part of our ‘Understanding Accountancy Terms’ series, we cover common terms you might find when running your own business. This time, we’re explaining the term ‘cost of sales’ – also known as ‘cost of goods sold’, or COGS for short.
What does ‘Cost of Sales’ mean?
Cost of sales or ‘cost of goods sold’ refers to how much it costs a business to make a sale. These are different to expenses, which don’t directly relate to individual sales like COGS do. An example of an expense might be office rental charges.
What kind of things should I include when working out the cost of sales?
The cost of a sale might include how much it costs to pay for :
raw materials to make products
materials for a builder
subcontractors carrying out the core service on offer
You should include these, even if you don’t actually pay for those costs at the same time as making the sale. It’s also worth noting that lots of expenses are ‘allowable’, which means you can claim for them on your tax return, and reduce the amount of tax that you pay.
The amount of money that it costs to produce products or sell services to your customers eats into amount of profit that you can make.
Knowing how much you have spent on making a sale will help you understand how efficiently the business operates, or where the business needs more attention. It’s also a key part of understanding gross profit.
Sales minus Cost of Sales = Gross Profit
Looking at gross profit as a percentage will help you understand if your pricing is correct. For example, retailers typically have a 50% to 70% gross profit margin. If the profit margin is only around 20% then this can indicate that the cost of sales is too high, or the retail price is too low.
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It’s one of many reason why good bookkeeping is so crucial. Categorising the items that you buy and sell helps you identify exactly where there are costs, and where you’re making money. It will help you calculate the cost of sales more accurately, helping you iron out problems in your gross profit margins.