Cost of sales explained: definition, formula, examples

Published Friday 13 February 2026

Table of contents

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

Key takeaways

• Calculate your cost of sales by including only direct expenses tied to producing or delivering your product or service, such as raw materials, direct labour, and shipping costs, while excluding general business expenses like rent, marketing, and administrative salaries.
• Track your cost of sales regularly (at least monthly) to spot rising expenses early, protect your profit margins, and make informed decisions about pricing adjustments or supplier negotiations.
• Apply the appropriate calculation method for your business type: service businesses should include direct labour and delivery costs, retailers should use the inventory formula (beginning inventory + purchases - ending inventory), and manufacturers should track raw materials, production labour, and manufacturing overhead.
• Reduce your cost of sales by negotiating better supplier terms, comparing supplier options regularly, improving production efficiency, and optimising inventory management to avoid overstocking or understocking.

What is cost of sales?

Cost of sales is the total amount you spend to deliver a product or service to a customer. International Accounting Standards guide the principles behind this metric and have been evolving since the 1990s. This metric is sometimes called cost of goods sold (COGS), though the two terms have subtle differences.

Knowing your cost of sales helps you make smarter financial decisions, from setting competitive prices to choosing the right suppliers.

For most small businesses, cost of sales equals direct costs: the expenses tied directly to the goods or services you sell. Don't confuse this with indirect costs, which are general business expenses unrelated to production or service delivery.

Cost of sales varies by business type:

• Retailers: stock purchases and packaging
• Service providers: software subscriptions and contractor fees
• Manufacturers: raw materials and production labour

Cost of sales vs COGS

Cost of sales and cost of goods sold (COGS) are often used interchangeably, but they have slightly different meanings.

COGS refers specifically to the direct costs of producing or purchasing goods for sale: raw materials, manufacturing labour, and production overhead.

Cost of sales is a broader term that includes COGS plus any additional costs to deliver a product or service, such as:

• Sales commissions
• Delivery and fulfilment costs
• Service delivery expenses

Which term should you use?

• Product-based businesses typically use COGS.
• Service businesses typically use cost of sales.
• Many small businesses use the terms interchangeably.

The important thing is to be consistent in how you calculate and report this figure.

Cost of sales vs expenses

Cost of sales covers expenses directly tied to producing or delivering what you sell. Expenses (or operating expenses) cover the broader costs of running your business.

Here's how to tell the difference:

• PR agency fees: A business expense, not cost of sales, because it promotes your brand rather than delivering your product
• Delivery fees: A cost of sales, because you can't complete a customer order without it

Track both figures to make smarter decisions:

• Low sales? Look at reducing operating expenses like marketing or rent.
• Shrinking margins? Focus on lowering your cost of sales through better supplier deals or process efficiency.

What should I include in cost of sales?

Include any expense directly tied to producing or delivering what you sell. Exclude general business costs that would exist regardless of sales volume.

Here are common items to include in your cost of sales calculation:

• Raw materials and inventory purchases
• Direct labour (production or service delivery staff)
• Manufacturing or production costs
• Shipping and fulfilment
• Packaging materials
• Sales commissions (if directly tied to transactions)

Here are common items to exclude from your cost of sales:

• Rent for general office space, which is governed by separate accounting standards like IFRS 16 Leases
• Marketing and advertising
• Administrative salaries
• Utilities (unless directly tied to production)
• Insurance and legal fees

If you're unsure whether a cost belongs in cost of sales, ask: "Would this expense exist if I made no sales?" If yes, it's likely an operating expense. If no, it's probably cost of sales.

How to calculate cost of sales in different industries

To calculate cost of sales, add up all direct costs involved in delivering your product or service. The specific formula depends on your business type.

Here are the standard approaches for service businesses, retailers, and manufacturers.

Cost of sales example formula for service businesses

Service businesses calculate cost of sales by adding all input costs directly tied to delivering client work.

Include these costs in your calculation:

• Salaries for employees who deliver services
• Workspace costs for service delivery
• Travel expenses for client work
• Equipment used to complete projects

Exclude these costs from your calculation:

• Back-office staff salaries (admin, HR, finance)
• General office expenses unrelated to service delivery

A freelancer working from home on a laptop may only need to include software subscriptions and their own time.

Cost of sales example formula for retailers

Retailers calculate cost of sales using an inventory-based formula:

Beginning inventory + Purchased inventory − Ending inventory = Cost of sales

For ecommerce businesses, you should also include these costs:

• Shipping and fulfilment costs
• Payment processing fees
• Packaging materials

This formula shows the actual cost of goods sold during a specific period.

Cost of sales example formula for manufacturing

Manufacturers calculate cost of sales by tracking all production-related expenses.

Include these costs in your calculation:

• Raw materials
• Direct labour (production staff wages)
• Manufacturing overhead (factory utilities, equipment maintenance)

These costs are optional, depending on your accounting approach:

• Warehousing costs
• Freight and logistics

Some manufacturers classify storage and freight as operating expenses rather than cost of sales. Choose one approach and apply it consistently.

Cost of sales examples

Some costs sit in a grey area. Sales commission, for example, could count as cost of sales or as an operating expense. The same applies to equipment repairs.

The key is consistency. Pick one approach and stick with it. If you include commission in cost of sales, include it every time. Inconsistent calculations make it harder to compare performance across periods or make sound pricing decisions.

Retail business example

Here's how a homeware store owner calculates cost of sales for handmade pottery cups.

Here's the cost breakdown per cup:

• Supplier cost: $2
• Shipping from supplier: $2
• Staff labour (shelving and sales assistance): $3

Total cost of sales: $10 per cup

To achieve a 50% profit margin, the owner sets a retail price of $15 per cup.

Why is cost of sales important?

Understanding your cost of sales helps you set profitable prices and spot margin problems early. The cost of sales figure is your pricing baseline: you need to charge above it to make a profit.

Some costs are easy to calculate, like employee wages. Others can surprise you. For example, an ecommerce business working from home may enjoy strong margins at first, but those margins shrink once you factor in warehouse rent or workspace costs.

Include both fixed costs and variable costs in your cost of sales calculation:

• Fixed costs: Expenses that stay consistent regardless of production volume, such as employee salaries.
• Variable costs: Expenses that change based on output, such as shipping fees or raw materials.

Your cost of sales should capture all direct costs tied to delivering your product or service, whether fixed or variable.

Costs change over time, so calculate your cost of sales regularly. Tracking this figure helps you:

• Spot rising expenses before they erode your margins.
• Decide when to adjust your prices.
• Identify suppliers or processes that need renegotiating.

How to reduce your cost of sales

Reducing your cost of sales improves profit margins and lets you price more competitively. Here are proven strategies:

• Negotiate with suppliers: Ask for volume discounts, better payment terms, or price matching.
• Compare supplier options: Shop around regularly for better deals on materials or stock.
• Improve production efficiency: Invest in technology, training, or process improvements that reduce waste.
• Optimise inventory management: Avoid overstocking (which ties up cash) and understocking (which costs sales). Inventory software can help, with one IDC study on a leading ERP system showing a 327% three-year ROI.
• Outsource strategically: Contract specialists for specific tasks instead of hiring full-time staff.

Review your cost of sales quarterly to identify new savings opportunities.

Simplify your cost tracking with Xero

Costs change constantly, and a clear tracking system helps you stay in control of your spending.

Xero gives you a live view of your income and outgoings, so you always know where your money goes. Use job costing software to track project profitability, and explore analytics and reporting features for cash flow projections, income reports, and financial statements.

Ready to take control of your costs? Get one month free and see how Xero simplifies cost tracking for your business.

FAQs on cost of sales

Here are answers to common questions about calculating and managing your cost of sales.

Is cost of sales an expense or income?

Cost of sales is an expense. It appears on your income statement (profit and loss) and reduces your gross profit. It's not classified as income because it represents money spent, not money earned.

What's a good cost of sales percentage?

A 'good' cost of sales percentage varies by industry. For manufacturers, it can easily comprise 50–60% of total expenses. Retailers typically see 60–80% of revenue go to cost of sales, while service businesses may run at 20–40%. Compare your percentage to industry benchmarks and track it over time to spot trends in your own business.

How does the cost of sales affect profitability?

Cost of sales directly reduces your gross profit. The higher your cost of sales relative to your selling price, the smaller your profit margin. Aim for a cost of sales that leaves room for healthy margins while keeping prices competitive.

How often should I calculate cost of sales?

Calculate cost of sales at least monthly to catch rising costs early. If your costs fluctuate frequently, or you're in a growth phase, review it weekly. Regular tracking helps you adjust pricing, renegotiate supplier terms, and protect your margins before problems compound.