Cost Of Sales: What It Is, Formulas, & How To Track

Published Friday 5 December 2025

Table of contents

• What is cost of sales?
• Why is cost of sales important?
• Cost of sales vs. expenses
• How to calculate cost of sales
• 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 all direct expenses tied to delivering your product or service, such as materials, labour, and shipping, while excluding general business overhead like rent or administrative costs.

• Track your cost of sales regularly to identify margin pressure early and make informed decisions about when to adjust pricing or reduce costs to maintain profitability.

• Apply different cost of sales formulas based on your business type—use beginning inventory plus purchases minus ending inventory for retailers, or focus on direct labour and service delivery costs for service businesses.

• Maintain consistency in how you classify expenses as either cost of sales or operating expenses to ensure accurate cost tracking and meaningful financial comparisons over time.

What is cost of sales?

Cost of sales is the total expense directly linked to providing your product or service to customers. This includes materials, labour, and other direct costs needed to deliver what you sell. You might also see it referred to as cost of goods sold (COGS). Understanding your cost of sales helps you set profitable prices and make smart sourcing decisions.

For most small businesses, cost of sales equals your :

• Direct costs: Expenses directly linked to creating your product or service
• Indirect costs: General business expenses not tied to specific sales (like rent or admin costs)

Cost of sales differs from business to business. A bricks-and-mortar retailer will have costs like stock and packaging, while a freelancer offering social media services needs to pay software subscriptions to deliver client work.

Why is cost of sales important?

Cost of sales is your profit baseline – you need to charge above this amount to earn a profit. Understanding these costs helps you determine which customers and products are most profitable for your business.

Labour costs are usually straightforward to calculate. Hidden costs often catch new business owners off guard.

For example, e-commerce businesses working from home initially have low overhead costs, as they can claim deductions for the portion of their home used for business. For the 2024–2025 tax year in New Zealand, the Inland Revenue Department (IRD) has set the square metre rate at $55.60. However, margins shrink when they need to pay for warehouses or dedicated workspace.

Include both fixed and variable costs that directly relate to delivering your product or service.

Fluctuating fixed and variable costs are another reason to calculate cost of sales regularly. That way, you can spot and deal with things that put pressure on your profit margins – such as rising delivery fees – and make the right call on when to raise your prices.

Your cost of sales includes two types of costs:

Fixed costs

These are expenses that stay the same regardless of sales volume:

• Employee salaries
• Equipment leases
• Software subscriptions

Variable costs

Variable costs are expenses that change based on production or sales

• Shipping fees
• Raw materials
• Transaction processing fees

Cost of sales vs. expenses

Cost of sales covers expenses directly tied to delivering your product or service. Business expenses cover general costs of running your company.

Business expense example: PR agency fees for brand coverage – not directly tied to individual sales

Cost of sales example: Delivery fees for online orders – essential for completing each sale

Track both metrics to make better financial decisions:

When sales drop: Focus on reducing general business expensesWhen profit margins shrink: Focus on reducing cost of sales

How to calculate cost of sales

The formula for cost of sales (COS) depends on whether you sell products or services. For businesses that sell physical goods, the calculation is straightforward.

The most common cost of sales formula is:

Beginning inventory + Purchases during the period – Ending inventory = Cost of sales

• Beginning inventory: The value of the inventory you had at the start of the period.
• Purchases: The cost of any new inventory you bought during the period.
• Ending inventory: The value of the inventory you have left at the end of the period.

This formula tells you the direct cost of the goods you actually sold. Service-based businesses calculate it differently, as they do not have inventory. Next, you will see examples for different industries.

How to calculate cost of sales in different industries

Depending on the type of business you run, you'll need to tweak the cost of sales equation for the most accurate result. Here are example equations for service businesses, retailers, and manufacturers.

Cost of sales example formula for service businesses

Service businesses typically include these costs:

Include in cost of sales:

• Employees who deliver services directly
• Facilities used for service delivery
• Travel costs for client work
• Equipment used for service delivery

Exclude from cost of sales:

• Back-office administrative staff
• General office overhead

Cost of sales example formula for retailers

Retailers use this formula for inventory tracking:

Standard retail costs:

• Product purchase price
• Shipping from suppliers
• Transaction processing fees
• Packaging materials

Cost of sales example formula for manufacturing

Manufacturers typically include:

Core manufacturing costs:

• Raw materials
• Production labour
• Manufacturing equipment usage

Optional costs (varies by business):

• Warehousing
• Freight shipping

Cost of sales examples

Unclear costs require judgment calls. Use this approach:

Ask yourself: Is this expense essential for completing each sale?

Examples of judgment calls:

• Sales commissions: Could be cost of sales or operating expense
• Equipment maintenance: Could be cost of sales (if production-specific) or an operating expense. Accounting standards also clarify related costs. For instance, you must recognise any proceeds from selling items produced while testing new equipment in profit or loss, and not deduct them from the asset’s cost.

Key principle: Stay consistent with your classification across all similar expenses.

Consistency is crucial for accurate cost tracking. Once you classify an expense as cost of sales, use the same classification every time. Inconsistent categorisation makes it impossible to compare costs across different sales or time periods.

Retail business example

So, what's the cost of sales for a retail business?

The owner of a homeware store applies the cost of sales formula for a new item – handmade pottery cups – so they can set a competitive, profitable price.

The owner buys the cups from a supplier for £5 each. To get the cups shipped from the supplier to the store costs £2. And when the cups arrive, an employee is responsible for putting them on the shelves and guiding customers towards the purchase. The cost of their labour equates to £3 per cup.

So the total cost of sales per cup is £10. For a 50% profit margin, the store owner settles on a retail price of £15 per handmade cup.

Simplify your cost tracking with Xero

The costs of running a business and making a sale change all the time. You need a simple way to monitor and manage your costs so you can keep your spending under control.

With Xero job costing software, you get a live view of your income and outgoings, so you always know the state of your finances.

You can also do deeper financial analysis using Xero analytics and reporting features. View cash flow projections, income and expenditure reports, and a range of financial statements and calculations to keep you in control of your numbers.

FAQs on cost of sales

Here are some common questions and answers to help you understand and manage your cost of sales.

How can I reduce my cost of sales?

Reducing cost of sales increases profit margins and helps you offer competitive pricing. Try these strategies:

Cost reduction strategies:

• Negotiate better terms with suppliers
• Shop around for cheaper raw materials
• Increase production efficiency with new technology
• Improve inventory management to avoid overstocking (inventory software can help with this)
• Outsource specific functions instead of hiring staff

How does the cost of sales affect profitability?

Cost of sales directly determines your profit. The gap between your selling price and cost of sales is your gross profit.

Example: £100,000 sales revenue – £90,000 cost of sales = £10,000 gross profit (only 10% margin)

Lower cost of sales means higher profit margins and more cash for your business.

Your cost of sales should leave room for a healthy profit, while still letting you set competitive prices for your customers.

What's the difference between cost of sales and cost of goods sold?

Cost of sales and cost of goods sold (COGS) are similar terms, but many businesses use them in slightly different ways:

Cost of sales:

• Used by service businesses
• Includes selling and distribution costs
• Covers commissions and transport fees

Cost of goods sold (COGS):

• Used by manufacturers and retailers
• Focuses on product creation costs
• Covers raw materials and manufacturing labour

Is cost of sales an expense or income?

Cost of sales is an expense. It represents the direct costs of producing the goods or services you've sold. You subtract it from your revenue to calculate your gross profit. It is not a form of income.