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

Published Tuesday 24 February 2026

Table of contents

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

Key takeaways

• Calculate your cost of sales by including only expenses directly tied to producing or delivering your product or service, such as raw materials, direct labour, packaging, and shipping costs, while excluding general business expenses like rent, marketing, and administrative salaries.
• Use the appropriate formula for your business type: service businesses should add labour plus facilities plus travel plus equipment costs, retailers should calculate beginning inventory plus purchases minus ending inventory, and manufacturers should combine raw materials plus production labour plus manufacturing overhead.
• Apply the simple test of asking "Does this expense increase when I make more sales?" to determine whether a cost belongs in your cost of sales calculation, and maintain consistent categorisation of grey-area expenses like sales commissions and equipment repairs.
• Track your cost of sales regularly to set profitable prices above your direct costs, identify when rising expenses are eating into your profit margins, and make informed decisions about suppliers and business growth.

What is cost of sales?

Cost of sales is the total cost of providing a product or service to a customer, with its calculation detailed in official accounting and reporting practices. You might also see it called cost of goods sold (COGS).

Understanding your cost of sales helps you:

• set competitive prices
• source suppliers effectively
• make confident financial decisions

For most small businesses, cost of sales equals direct costs: the expenses directly linked to the goods or services you sell.

This differs from indirect costs, which are general business expenses that don't relate to making products or delivering services.

Cost of sales varies by business type:

• Retailers: stock, packaging, and shipping
• Freelancers: software subscriptions and tools needed for client work

Cost of sales vs cost of goods sold

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 goods, and US GAAP provides specific guidance that these include direct materials, direct labour, and overhead costs. It's typically used by businesses that make or trade physical products.

Cost of sales is a broader term that includes all costs tied to delivering a product or service. Service businesses often prefer this term because it covers expenses like labour, software, and transport that don't fit neatly into "goods."

Cost of goods sold (COGS):

• Best for: Manufacturers and retailers
• Includes: Raw materials, production labour, inventory costs

Cost of sales:

• Best for: Service and product businesses
• Includes: All direct costs of delivery, including labour and software

For most small businesses, the terms work the same way in practice. Choose the one that best describes your business model and use it consistently.

What to include in your cost of sales calculation

Include any expense directly tied to producing or delivering your product or service. The specific items depend on your business type, but the rule is simple: if you couldn't make the sale without it, it's likely a cost of sale.

Common costs to include:

• raw materials and inventory
• direct labour (employees who make or deliver products)
• packaging and shipping
• software and tools required for service delivery
• sales commissions tied to specific transactions
• subcontractor fees for client work

Costs to exclude:

• rent and utilities (unless for a dedicated production space)
• marketing and advertising
• administrative salaries
• office supplies
• insurance and professional fees

If you're unsure whether to include a cost, ask yourself: "Does this expense increase when I make more sales?" If yes, it's probably a cost of sale. If the expense stays the same regardless of sales volume, it's likely an operating expense.

How to calculate cost of sales in different industries

The cost of sales formula changes depending on your business type. Choose the formula that matches how you deliver value to customers.

Here are example calculations for service businesses, retailers, and manufacturers.

Cost of sales example formula for service businesses

Service business cost of sales = labour + facilities + travel + equipment

Service businesses calculate cost of sales by adding up input costs directly tied to delivering services.

Include:

• employees who deliver services to clients
• workspace costs for service delivery
• travel expenses for client work
• equipment used to complete projects

Exclude:

• back-office employees (admin, HR, finance)
• general office costs not tied to service delivery

For freelancers working from home, travel and equipment costs may not apply.

Cost of sales example formula for retailers

Retail cost of sales = beginning inventory + purchases − ending inventory

This formula is based on the retail inventory method, which is an acceptable method for estimating inventories for income tax purposes.

This formula tracks how much inventory you've sold during a period.

For ecommerce businesses, add these common costs:

• shipping fees
• transaction fees (payment processing)
• packaging materials

These expenses occur with every sale and directly affect your margins.

Cost of sales example formula for manufacturing

Manufacturing cost of sales = raw materials + production labour + manufacturing overhead

Manufacturers include all costs directly tied to producing goods.

Typically included:

• raw materials
• production labour
• factory overhead (utilities, equipment maintenance)

May be included or excluded:

• warehousing costs
• freight and distribution

While some manufacturers treat warehousing and freight as operating expenses, major accounting standards consider freight a part of the cost of sales if the goods are shipped to the customer. Choose the approach that best reflects your production process and apply it consistently.

Cost of sales examples

Some expenses fall into a grey area. The key rule: be consistent with how you categorise costs.

Common grey areas:

• Sales commission: can be included as cost of sales (tied to each transaction) or as an operating expense
• Equipment repairs: can be cost of sales (if the equipment makes your product) or operating expense (general maintenance)

Once you decide how to treat these costs, apply the same approach every time. Inconsistent categorisation creates unreliable figures and makes it harder to track your true margins.

Retail business example

Say you own a homeware store and want to price handmade pottery cups profitably. Here's how you'd calculate cost of sales:

Cost breakdown per cup:

• Purchase price from supplier: $5
• Shipping from supplier to store: $2
• Staff labour (shelving and sales): $3

Total cost of sales: $10 per cup

To achieve a 50% profit margin, you'd set the retail price at $15.

Why is cost of sales important?

Cost of sales tells you the minimum you need to charge to make a profit. Without this number, you're guessing at prices and margins.

Understanding your cost of sales helps you:

• Set profitable prices: charge above your cost of sales to ensure every sale contributes to profit
• Spot margin pressure: identify when rising costs (like delivery fees) eat into your profits
• Make sourcing decisions: compare suppliers based on how they affect your bottom line
• Plan for growth: anticipate how costs will change as your business scales

Hidden costs: Ecommerce businesses that start from home often enjoy strong margins at first. But those margins can shrink quickly when you need to pay for warehouse space or additional staff. Calculate your cost of sales regularly to catch these changes early.

Consider whether each cost is fixed or variable when calculating your cost of sales.

• Fixed costs stay the same regardless of how much you produce. Employee salaries are a common example: they don't change based on how many units you sell.
• Variable costs change with production levels. Shipping costs, for instance, depend on the supplier, distance, and quantity delivered.

Include both types in your cost of sales calculation if they're directly tied to delivering your product or service.

Cost of sales vs expenses

Cost of sales covers expenses directly tied to making a sale. Business expenses (also called operating expenses) cover the costs of running your business, whether you make sales or not.

Here's how to tell the difference:

• PR agency fees: a business expense (helps build your brand, but isn't required to complete a sale)
• Delivery fees: cost of sales (you can't complete the sale without delivering the product)

Both numbers matter for different decisions:

• Shrinking profit margins? Look at reducing your cost of sales
• Low sales volume? Focus on cutting business expenses

Track both figures to understand where your money goes and where you have room to improve.

Simplify your cost tracking with Xero

Automate your cost tracking and spend more time running your business. Xero gives you a live view of your income and outgoings, so you always know your true margins.

With Xero, you can:

• track cost of sales automatically as you record transactions
• view real-time reports on profitability and cash flow
• spot cost increases before they hurt your margins
• make confident pricing decisions based on accurate data

Ready to take control of your costs? Get one month free and see how Xero makes cost tracking effortless.

FAQs on cost of sales

Here are answers to some common questions about 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 income because it represents money going out of your business, not coming in.

What is a good cost of sales percentage?

A good cost of sales percentage depends on your industry. For many retailers, a cost of sales percentage that results in a gross profit margin of 50% to 70% is considered healthy, while many service businesses often target a lower cost of sales percentage of 15–30%.

Calculate your cost of sales percentage by dividing cost of sales by total revenue, then multiplying by 100. Compare your result to industry benchmarks and track it over time to spot trends.

How can I reduce my cost of sales?

Reduce your cost of sales by lowering the direct costs of delivering your product or service. Here are practical ways to do it:

• Negotiate with suppliers for better prices or payment terms.
• Compare suppliers to find better deals on raw materials or stock.
• Improve production efficiency with new technology or training.
• Manage inventory better to avoid overstocking or stockouts (inventory software can help with this).
• Outsource specific tasks instead of hiring full-time staff.

Small improvements across several areas can significantly boost your margins over time.

How does the cost of sales affect profitability?

Cost of sales directly determines your profit margin. The smaller the gap between your cost of sales and your selling price, the less profit you keep.

Example: If you generate $100,000 in sales but your cost of sales is $90,000, you're left with just $10,000 in gross profit (a 10% margin).

Aim for a cost of sales that leaves room for healthy profit while keeping your prices competitive.