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

Published Thursday 29 January 2026

Table of contents

• What is cost of sales?
• Why is cost of sales important?
• What to include in cost of sales
• 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 tied to creating and delivering your products or services, such as materials, production labor, shipping, and packaging, while excluding indirect expenses like rent, marketing, and administrative salaries.
• Track both fixed costs that stay consistent regardless of sales volume and variable costs that change with production to get an accurate profit baseline and set prices that generate healthy margins.
• Monitor your cost of sales monthly to catch rising expenses early and adjust your pricing before they impact profit margins, ensuring you maintain profitability as business conditions change.
• Reduce your cost of sales by negotiating better supplier terms, sourcing alternative materials at lower costs, improving production efficiency, and optimizing inventory management to boost your bottom line.

What is cost of sales?

Cost of sales is the total expense of producing and delivering your products or services to customers. This includes direct costs like materials, labor, and shipping that are essential for each sale. 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.

Direct costs make up your cost of sales: expenses tied specifically to creating and delivering your products or services. These differ from indirect costs like rent or marketing that support your business but don't directly create products.

Cost of sales varies by business type:

• Retailers: inventory, packaging, shipping costs
• Service providers: software subscriptions, contractor fees
• Manufacturers: raw materials, production labor, equipment use

Why is cost of sales important?

Cost of sales establishes your profit baseline, which is the minimum you must charge to avoid losing money on each sale. Understanding these costs helps you set prices that generate profit and identify which products or services deliver the best returns.

Fixed and variable costs both impact your cost of sales calculation. Understanding the difference helps you predict how costs change as your business grows.

Fixed costs stay consistent regardless of sales volume:

• Employee salaries
• Equipment leases
• Software subscriptions

Variable costs change based on production or sales:

• Raw materials
• Shipping fees
• Transaction processing

Include both types when calculating your total cost of sales to get an accurate profit baseline.

Regular cost tracking helps you maintain profitable pricing as expenses change. Monitor your cost of sales monthly to catch rising costs early and adjust prices before they impact your profit margins.

What to include in cost of sales

To calculate your cost of sales accurately, you need to separate the direct costs of producing and selling your goods or services from your general business expenses. Only include costs that are directly tied to what you sell. For example, one major retailer's definition of cost of goods sold (COGS) includes not just inventory, but also warehousing costs, distribution payroll, and inventory shrink costs.

Costs typically included in your cost of sales calculation are:

• Direct materials: The raw materials used to create your product.
• Direct labor: Wages for the staff who directly produce your goods or deliver your services.
• Production supplies: Items consumed during production that aren't part of the final product.
• Shipping and freight: Costs to get raw materials to you or finished products to customers.
• Packaging: The cost of boxes, labels, and other materials for packaging your product.

On the other hand, you should exclude indirect costs, which are general operating expenses. These include:

• Marketing and advertising costs
• Administrative salaries (like HR or accounting staff)
• Rent and utilities for your main office
• General office supplies

Being consistent with what you include and exclude is the most important part. This ensures your calculations are reliable over time.

Cost of sales vs. expenses

Cost of sales includes only expenses directly tied to creating and delivering your products or services. Business expenses cover all other costs needed to run your company, like rent, marketing, and administrative salaries.

Here's how to categorize common costs:

Business expenses (not cost of sales):

• PR and marketing agencies
• Office rent and utilities
• Administrative staff salaries

Cost of sales (directly tied to each sale):

• Product delivery and shipping
• Payment processing fees
• Materials and packaging

Track both metrics to make informed financial decisions. When sales volume drops, focus on reducing business expenses. When profit margins shrink, work on lowering your cost of sales through better supplier deals or process improvements.

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 include these direct costs in their cost of sales calculation:

• Service delivery staff wages
• Client-facing workspace costs
• Travel expenses for client work
• Equipment used for service delivery

Exclude:

• Administrative staff salaries
• General office expenses
• Marketing costs

Cost of sales example formula for retailers

Retailers calculate cost of sales using inventory values plus direct selling costs:

Core formula: Beginning inventory + purchases - ending inventory = cost of sales

Additional costs to include:

• Shipping and delivery fees
• Payment processing charges
• Packaging materials

Cost of sales example formula for manufacturing

Manufacturers include production-related costs in their cost of sales:

• Raw materials and components
• Production labor costs
• Manufacturing equipment use

May vary by business:

• Warehousing costs
• Freight and logistics

Choose consistent categorization and apply it across all calculations.

Cost of sales examples

Consistency matters more than perfect categorization when you calculate cost of sales, because even large companies adjust their definitions. One firm cut its reported cost of goods sold from $12.6 billion to $12.2 billion for the fiscal year by reclassifying certain expenses. Choose clear rules for borderline costs and apply them every time.

Common borderline costs:

• Sales commissions: Include if tied to specific sales
• Equipment maintenance: Include if used directly for production
• Quality control: Include if part of delivery process

Retail business example

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

• Product cost: $5.00 (supplier price)
• Shipping: $2.00 (delivery to store)
• Labor: $3.00 (stocking and sales support)
• Total cost of sales: $10.00

Pricing decision: To achieve a 50% profit margin, the store sets the retail price at $15.00 per cup.

Simplify your cost tracking with Xero

The costs of running a business and making a sale change all the time. With a simple way to monitor and manage your costs, you can stay in control of your spending.

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 run 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. Get one month of Xero free and try it out.

FAQs on cost of sales

Here are answers to some common questions about cost of sales.

How can I reduce my cost of sales?

There are several practical ways you can bring your cost of sales down:

• Negotiate with suppliers for better pricing or payment terms
• Source alternative materials or inventory at lower costs
• Improve production efficiency with better technology or training
• Optimize inventory management to reduce carrying costs
• Outsource specific functions instead of hiring full-time staff

How does the cost of sales affect profitability?

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

Example: $100,000 in sales revenue minus $90,000 cost of sales leaves only $10,000 gross profit – just a 10% margin.

Aim for cost of sales that allows healthy profits while keeping prices competitive in your market.

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

Cost of sales and cost of goods sold (COGS) are similar but work best for different types of businesses.

Cost of sales works well for:

• Service businesses (including delivery, commission, and transport)
• Companies with different types of revenue
• Businesses selling both products and services

COGS works better for:

• Product manufacturers (focused on production costs)
• Retailers selling physical goods
• Businesses with primarily inventory-based sales

Both measure direct costs, but cost of sales covers a broader range of selling expenses.