Cost of Sales

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Cost of sales refers to the direct costs attributable to the production of goods or rendering of services by an entity. It is also commonly referred to as "cost of goods sold (COGS)".

Cost of sales measures the cost of goods produced or services provided by an entity during a period. It includes the cost of the direct materials used to produce the goods, the direct labor used to produce the goods, and all other direct costs associated with the production of the goods. In the case of services, cost of sales includes the labor costs or salaries of the employees and other directly attributable costs.

Cost of sales does not include indirect expenses such as distribution costs and marketing costs. It appears in the income statement and is deducted from sales revenue to calculate gross profit (or gross margin).

The exact costs included in the calculation of cost of sales vary from one type of business to another. The cost of sales attributable to an entity's products or services is expensed as the entity sells those goods.

Because cost of sales does not include overhead, it has a higher proportion of variable costs than operating costs. Some fixed costs, such as labor costs, may be included in the cost of sales. In most cases, however, the cost of sales consists almost entirely of variable costs.

Because inventory may be revalued, the cost of sales in a particular period reflects both any revaluation of inventory and the methods of allocating the cost of inventory, such as first-in, first-out (FIFO) and average cost. The methods used to allocate overhead costs to particular products also affect the cost of sales.

There are several ways to calculate the cost of goods sold. The basic and most commonly used method is described here. This method starts with the beginning inventory for the period, adds the total amount of purchases made during the period, and then subtracts the ending inventory. This calculation gives the cost of the inventory sold by the company during the period.

Cost of Sales According to IFRS and US GAAP

According to International Financial Reporting Standards (IFRS) and United States Generally Accepted Accounting Principles (US GAAP), the cost of sales is defined as the direct costs incurred in the production of goods or services that are sold to customers. These costs include the cost of materials, direct labor, and other direct expenses that can be directly attributed to the production of a specific product or service.

IFRS and US GAAP have some minor differences in the way cost of sales is accounted for. For example, under IFRS, inventory is measured at the lower of cost or net realizable value, while under US GAAP, it is measured at the lower of cost or market. Additionally, US GAAP provides more specific guidance on accounting for production costs, such as specifying that direct materials, direct labor, and overhead costs should be assigned to specific units of production using specific identification, or using a method such as process costing or normal costing.

Both IFRS and US GAAP require that the cost of sales is matched with the corresponding revenue in the period in which the goods or services are sold. This is known as the matching principle.

Financial Ratios Calculated using Cost of Sales

Several financial ratios can be calculated using the cost of sales:

Gross margin ratio: This ratio compares the cost of sales to the revenue, and is calculated as (Gross Profit / Revenue) * 100. It indicates the percentage of revenue that is left over after the cost of goods sold is subtracted.

Gross profit margin: This ratio compares the gross profit to the revenue, and is calculated as (Gross Profit / Revenue) * 100. It measures the efficiency of a company's production and distribution processes.

Operating profit margin: This ratio compares the operating profit to the revenue, and is calculated as (Operating Profit / Revenue) * 100. It measures the efficiency of a company's operations and management.

Net profit margin: This ratio compares the net profit to the revenue, and is calculated as (Net Profit / Revenue) * 100. It measures the overall profitability of a company, taking into account all expenses, including taxes and interest.

Contribution Margin: This ratio compares the contribution margin (sales minus variable cost of sales) to the revenue, and is calculated as (Contribution Margin / Revenue) * 100. It measures the profit generated by each unit sold.

These ratios can be used to evaluate the company's financial performance over time, and to compare it with that of other companies in the same industry.

How to Reduce Cost of Sales?

There are several ways to reduce the cost of sales, including:

  1. Negotiating better deals with suppliers to lower the cost of goods sold.

  2. Implementing more efficient processes to reduce labor costs.

  3. Automating certain sales tasks to reduce the need for human labor.

  4. Outsourcing non-core functions to lower cost providers.

  5. Reducing marketing expenses by focusing on cost-effective channels.

  6. Increasing the efficiency of your sales team by providing better training and tools.

  7. Implementing inventory management to reduce waste and optimize stock levels.

  8. Analyzing your sales data to identify and eliminate underperforming products or sales channels.

It's also important to note that cost reduction should be done in a way that does not negatively impact the customer experience or the quality of your products or services.

Quote Thandeka, 24 August, 2015
Can i include the machine hire as a coast of sales of Civil Construction company?
Quote Guest, 21 June, 2016
Yes, provided that the machine rented was solely rented to aid in the production of that product.
Quote Guest, 9 December, 2016
Can i include " Repair and maintenance of vessels " as a COS for a shipping company?
Quote Guest, 7 March, 2019
isn't the labor costs is a type of variable cost? How can it be a fixed cost?
Quote Guest, 10 April, 2019
Do we need to add the Manager's salary in the cost of sales ( service sector )
Quote jane, 11 September, 2019
does this include FREIGHT cost?
Quote Guest, 7 February, 2020

Whether or not freight costs are included in the cost of sales depends on the nature of the business and the specific accounting standards being applied.

Under IFRS and US GAAP, freight costs are typically considered to be a part of the cost of sales if the goods being sold are shipped to the customer. This is because the freight costs are considered to be directly associated with the production and sale of the goods. In this case, the freight costs are included in the cost of goods sold and reduces the gross profit.

However, if the goods are sold FOB (Free on Board) meaning the goods are shipped to the customer at the customer's expense, the freight costs will not be included in the cost of sales. Instead, they will be considered as a separate line item in the income statement, usually under selling and administrative expenses.

It's important to consult with your accountant or review the specific accounting guidance to ensure you are accounting for freight costs correctly.

Quote Guest, 17 August, 2020
How about lease expense on clinic premises for Hospita company, does it pertains to cost of service also?
Quote Guest, 30 January, 2021
Wages of labour and cost of labour - When you allocate it in cost of sales and when in cost of production
Quote Guest, 22 February, 2021
Hi. I am doing a delivery service business. I am wondering whether my delivery workers full time and part time salaries are included inside direct cost under cost of service delivery. Is this correct? Or is my delivery workers salaries full time & part time supposed to be under operating expenses (indirect cost)? Please help me because I am confused. thank you.
Quote Guest, 21 May, 2021
Quote
Guest wrote:
Hi. I am doing a delivery service business. I am wondering whether my delivery workers full time and part time salaries are included inside direct cost under cost of service delivery. Is this correct? Or is my delivery workers salaries full time & part time supposed to be under operating expenses (indirect cost)? Please help me because I am confused. thank you.
Whether the cost is indirect or direct depends on what service your business is providing. If your business was making books, the wages of delivery drivers would be an indirect cost. However, as in your case the business itself is a delivery service then the service you're providing is the delivery itself and in that case the wages of the delivery drivers are a direct cost. Hope that helps.

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