Cost of sales: what it is and how to calculate yours

Published Friday 17 April 2026

Table of contents

• What is cost of sales?
• Why is cost of sales important?
• What to include in your cost of sales calculation
• Cost of sales vs. expenses
• How to calculate cost of sales in different industries
• Cost of sales examples
• Simplify your cost tracking with Xero
• FAQs on cost of sales

Key takeaways

• Calculate your cost of sales by including only direct costs — such as raw materials, production labour, packaging, and shipping — and leave out overheads like rent, marketing, and admin salaries to get an accurate profit baseline.
• Use your cost of sales figure to set a minimum viable price, ensuring every product or service you sell is priced above this threshold to protect your profit margins.
• Apply different cost of sales formulas depending on your business type — service businesses focus on labour and delivery costs, retailers track inventory and shipping, and manufacturers include raw materials and production expenses.
• Stay consistent in how you categorise borderline costs, such as sales commissions or freight, so your financial reports remain reliable and support better pricing and forecasting decisions over time.

What is cost of sales?

Cost of sales is the total expense directly linked to delivering your products or services to customers. It includes raw materials, labour, packaging, and shipping.

This figure sets your minimum pricing threshold, directly impacts your profit margins, and serves as the most accurate metric for predicting business turnover.

For most small businesses, cost of sales is the same as direct costs, which are expenses tied to the goods or services you sell. These differ from indirect costs, which are general expenses not directly related to production or delivery.

Cost of sales varies by business type:

• Retailer: includes stock purchases and packaging
• Freelancer: includes software subscriptions to deliver client work

Why is cost of sales important?

Cost of sales matters because it sets your profit baseline. You need to price above this figure to stay profitable.

Tracking cost of sales regularly helps you:

• Set prices: establish your minimum viable price point
• Protect profits: spot margin threats early
• Control costs: identify which expenses are rising fastest

Regular monitoring helps you adjust prices before costs reduce your profit margins.

What to include in your cost of sales calculation

To get an accurate cost of sales figure, know what to include.

Costs to include in your calculation:

• purchasing raw materials or stock
• paying wages for staff who directly make products or deliver services
• covering other direct costs, such as shipping for materials or software needed to do the work

According to Australian Accounting Standards, this covers all costs of purchase, conversion, and other expenses required to get inventory ready for sale.

You also need to know what to leave out. General business running costs, also called indirect costs or overheads, don't belong in your cost of sales.

Costs to exclude from your calculation:

• paying administrative overheads
• spending on marketing and advertising
• covering office rent and utilities
• paying selling costs

According to AASB 102, these costs are excluded from inventory calculations and must instead be recognised as expenses under AASB standards in the period they are incurred. Be consistent in what you include to keep your reports reliable and support better business decisions.

Cost of sales vs. expenses

Cost of sales includes only expenses directly tied to creating and delivering your products or services. Business expenses cover everything else needed to run your company.

Cost of sales examples:

• purchasing raw materials and inventory
• paying direct labour costs
• covering packaging and shipping
• paying payment processing fees

Business expenses examples:

• paying for marketing and advertising
• covering office rent and utilities
• paying administrative salaries
• hiring professional services such as accounting and legal

To improve profit margins, focus on reducing cost of sales. To lower overall expenses, look at general business costs.

How to calculate cost of sales in different industries

Different business types need different cost of sales calculations. Service businesses focus on labour and delivery costs. Retailers track inventory and shipping. Manufacturers include raw materials and production expenses.

Cost of sales example formula for service businesses

Service businesses include all input costs tied to delivering services to clients.

Costs to include:

• paying employees who deliver services
• using facilities for service delivery
• covering travel costs if applicable
• using equipment for client work

Exclude back-office employees from cost of sales. Travel and equipment costs only apply if you work outside your home.

Cost of sales example formula for retailers

Retailers can use this cost of sales formula for inventory accounting, keeping in mind that ATO benchmarks for medium-sized retail businesses show cost of sales at an average of 52% of annual turnover.

Costs to include:

• calculating beginning inventory value
• adding purchased inventory
• including shipping to customers
• adding transaction fees

Subtract your ending inventory value to calculate your cost of sales.

Cost of sales example formula for manufacturing

Manufacturers have raw materials and production costs to consider in their cost of sales calculations.

Costs to include:

• purchasing raw materials
• paying manufacturing labour
• covering production overhead
• including storage if directly tied to production
• including freight if directly tied to production

You may exclude warehousing or freight if you treat these as operating expenses. Be consistent in your approach.

Cost of sales examples

For borderline expenses, consider: does this cost directly help you create or deliver your product or service? For unique items, accounting standards require the specific identification of their individual costs.

Common grey areas:

• Sales commissions: include if tied to specific sales; exclude if salary-based
• Equipment maintenance: include if used exclusively for production; exclude if shared across business
• Freight costs: include if delivering to customers; exclude if receiving inventory

Be consistent. If you change how you categorise costs, your tracking becomes unreliable.

Retail business example

Imagine you own a homeware store and want to price a new item: handmade pottery cups.

Calculation breakdown:

• purchasing from supplier: $5 per cup
• shipping to store: $2 per cup
• paying employee labour for shelving and customer service: $3 per cup

Total cost of sales per cup: $10

For a 50% profit margin, you would set a retail price of $15 per handmade cup.

Simplify your cost tracking with Xero

Business costs change often. A simple way to monitor and manage costs helps you stay in control.

With Xero Projects job costing, you get a live view of your income and outgoings. You can also do deeper financial analysis using analytics and reporting features, including cash flow projections and income and expenditure reports.

Get one month free and see how Xero makes cost tracking simple.

FAQs on cost of sales

Here are answers to common questions about cost of sales.