Cost of Sales (COGS): Definition, Formula & Examples

If you've ever looked at your accounts and wondered why your profit isn't what you expected, your cost of sales is usually the first place to look. It's the figure that sits between your revenue and your gross profit, and it decides how much of every sale you actually keep.

This guide explains what cost of sales (also called cost of goods sold, or COGS) means in UK accounting, how to calculate it for different business types, what to include and what to leave out, and how it shapes your gross profit margin. It's written for small business owners, ecommerce sellers and contractors who want a clear, practical answer without the jargon.

We've kept the examples generic on purpose, so you can map them onto your own numbers.

What does cost of sales mean in accounting? {#what-does-cost-of-sales-mean}

In accounting, cost of sales is the direct cost your business incurs to produce or buy in the goods and services it sells. It's the money you spend specifically to generate a sale, rather than the general cost of keeping the business running.

A simple test helps. If you didn't make a particular sale, would you still have spent that money? If the answer is no, it's likely part of your cost of sales.

Cost of sales has a few defining features:

• Direct link to revenue. The cost is tied to producing or acquiring what you sell.
• Variable. It usually rises and falls with your sales volume.
• Production focused. It relates to making, buying in or delivering your core offering.

For a bakery, cost of sales includes flour, sugar, eggs and the bakers' time on the production line. For a clothing retailer, it's the wholesale cost of the garments they resell. For a consultancy, it might be the subcontractor fees for delivering a specific client project.

Get this figure right and you can see how much profit your core activity really makes, before overheads ever come into it. If you'd rather hand the whole picture to someone else, our bookkeeping services keep your cost of sales accurate month to month.

What is the cost of sales formula? {#cost-of-sales-formula}

The principle is the same for everyone, but the exact formula depends on whether you sell stock, make products or deliver services.

The formula for retailers and resellers

The classic version, used by anyone who buys stock to resell, is:

Cost of sales = Opening stock + Purchases − Closing stock

It captures the stock you started with, the stock you bought during the period, and the stock still sitting on the shelf at the end.

The formula for manufacturers

Manufacturers add their production costs into the mix:

Cost of sales = Opening stock + Direct materials + Direct labour + Manufacturing overheads − Closing stock

That brings in raw materials, the wages of production staff, and the factory overheads directly tied to making the goods.

Illustrative example: a clothing shop

A clothing shop starts January with £10,000 of stock. During the month it buys £25,000 of new inventory. At the end of January, £8,000 of stock remains.

• Opening stock: £10,000
• Add purchases: £25,000
• Less closing stock: £8,000
• Cost of sales = £27,000

So the shop spent £27,000 to support its January sales. If it took £50,000 in sales that month, its gross profit is £23,000 (£50,000 − £27,000).

Cost of sales vs cost of goods sold: what's the difference? {#cost-of-sales-vs-cogs}

Talk to a bookkeeping specialist →

In practice, cost of sales and cost of goods sold (COGS) mean the same thing, and accountants use the terms interchangeably.

There's a soft convention about which one people reach for:

• Cost of goods sold (COGS) tends to come up in retail and manufacturing, where the emphasis is on physical goods.
• Cost of sales is the broader term, common in UK accounts and with service businesses, because it covers both goods and services.

Both appear in exactly the same place on the income statement and do the same job: showing the direct cost of generating revenue so you can work out gross profit. Don't get hung up on the label. Most accounting software accepts either.

What does cost of sales include? {#what-cost-of-sales-includes}

Cost of sales includes the direct costs you wouldn't have incurred without making that sale. What counts depends on your business model.

For product-based businesses

• Finished goods bought in for resale
• Raw materials for manufacturing
• Work in progress
• Packaging that forms part of the product
• Direct labour (production staff)
• Inbound freight to get stock to you
• Import duties on goods you bring in

For service businesses

• Subcontractors delivering the core service
• Freelancers hired for a specific client project
• Materials consumed while delivering the work
• Travel directly billed to or required for a client job

For construction and trades

• Building materials
• Plant or equipment hire for a specific job
• Subcontractor labour
• Site-specific supplies

A useful timing rule: include a cost when it's incurred, not when you pay for it. Under the accruals basis, the date the cost arises is what matters for matching it against the related sale.

What the accounting standards say about valuing stock

Your closing stock figure feeds straight into your cost of sales, so how you value it matters. UK businesses generally follow FRS 102 or FRS 105, which require stock to be measured at the lower of cost and estimated selling price less costs to complete and sell (often still called net realisable value).

HMRC accepts the same approach for tax. Its guidance confirms that valuing trading stock at the lower of cost and net realisable value is an acceptable basis, with the modern wording set out under FRS 102 and FRS 105 (see HMRC BIM33115).

What should I not include in cost of sales? {#what-to-exclude}

Knowing what to leave out is just as important. These are general running costs, so they sit below gross profit as operating expenses, not in cost of sales:

• Rent and utilities for your office or premises
• Marketing and advertising
• Office and admin salaries
• Professional fees (accountants, solicitors)
• Insurance premiums
• Software subscriptions
• Depreciation on office equipment
• Bank charges and interest
• General repairs and maintenance

Why does it matter? Mixing operating costs into cost of sales distorts your gross profit margin and hides how your core activity is really performing.

The quick test again: "Would I still have this cost if I made zero sales this month?" If yes, it's an operating expense, not cost of sales.

What do cost of sales examples look like by industry? {#examples-by-industry}

The principle is the same, but the line items differ. The figures below are illustrative examples to show the shape of each calculation, not real businesses.

Illustrative example: online clothing retailer

Excludes: website hosting, marketing, warehouse rent, office salaries.

If you sell online, our ecommerce accounting page covers how platform fees and stock costs fit together.

Illustrative example: furniture manufacturer

Excludes: showroom costs, sales team salaries, design office expenses.

Illustrative example: marketing agency

Excludes: office rent, permanent staff salaries, software subscriptions, business development.

Illustrative example: building contractor

Excludes: van insurance, office admin, quotation time, tool purchases.

Illustrative example: importer bringing stock into the UK

Import duties belong in cost of sales because they're part of bringing stock to a saleable condition. If you're VAT registered, import VAT is excluded from cost of sales because you reclaim it.

How do inventory valuation methods affect cost of sales? {#inventory-valuation}

The method you use to value stock changes your closing stock figure, which in turn changes your cost of sales. UK businesses commonly use one of these:

• FIFO (first in, first out). Assumes the oldest stock sells first. When prices are rising, FIFO gives a lower cost of sales and a higher reported profit, because older, cheaper stock is matched against current sales.
• Weighted average cost. Averages the cost per unit across all stock. It smooths out price swings and suits retailers with large volumes of similar items.

UK accounting standards (FRS 102 and FRS 105) do not permit LIFO (last in, first out) for financial statements, so most UK businesses use FIFO or weighted average.

Illustrative example: how the method changes the answer

A retailer buys 100 units at £10 each in March, then 100 units at £12 each in April. In May it sells 100 units for £20 each (£2,000 of revenue).

FIFO

• Cost of sales = 100 × £10 = £1,000
• Gross profit = £2,000 − £1,000 = £1,000

Weighted average cost

• Average cost = (£1,000 + £1,200) ÷ 200 = £11 per unit
• Cost of sales = 100 × £11 = £1,100
• Gross profit = £2,000 − £1,100 = £900

That £100 difference flows straight into your gross profit and your taxable profit. It's worth being consistent year to year, and worth a quick chat with your accountant before you switch methods.

How does cost of sales appear on the income statement? {#income-statement}

Cost of sales sits near the top of your income statement (also called the profit and loss account), just below revenue. That position shows the direct link between sales and the costs needed to make them.

This structure gives you three useful profit levels:

• Gross profit: revenue minus cost of sales, showing core performance.
• Operating profit: gross profit minus operating expenses, showing day-to-day efficiency.
• Net profit: what's left after interest and tax.

Is cost of sales a debit or a credit? {#debit-or-credit}

Cost of sales is an expense, and in double-entry bookkeeping expenses are debits. So cost of sales is recorded as a debit.

When you incur a cost to make sales, you debit the cost of sales account and credit either your bank (if you pay straight away) or your creditors (if you pay later). A typical entry looks like this:

As a quick refresher: assets and expenses increase with debits, while liabilities, equity and income increase with credits. Because cost of sales is an expense, its debit balance reduces your profit, which is exactly what you'd expect an expense to do.

Why does cost of sales matter for your business? {#why-it-matters}

Getting cost of sales right is fundamental to running a profitable business. Here's what it gives you.

It reveals your gross profit margin

Your gross profit margin is the share of revenue left after direct costs. It tells you whether your pricing is sustainable.

Gross profit margin = (Gross profit ÷ Revenue) × 100

A business with £100,000 of revenue and £60,000 of cost of sales has £40,000 of gross profit, a 40% margin.

It shows whether you're getting more or less efficient

Tracking cost of sales as a percentage of sales over time tells you if production is getting leaner or slipping. A rising percentage can signal supplier price rises you haven't passed on, more waste, or prices set too low.

It guides pricing

Once you know your cost of sales, you can set a price that covers direct costs plus a margin for overheads and profit, rather than guessing.

It supports planning and tax accuracy

If you know roughly what each sale costs to fulfil, you can forecast costs at different revenue levels. Accurate stock valuation also keeps your taxable profit right, which matters because HMRC expects trading stock to be valued correctly when you work out your profits (see HMRC BIM33115).

How do you work out the cost of sales percentage? {#cost-of-sales-percentage}

The cost of sales percentage shows how much of your revenue goes on direct costs. It's the mirror image of your gross profit margin.

Cost of sales % = (Cost of sales ÷ Revenue) × 100

Illustrative example: a restaurant

• Monthly revenue: £50,000
• Cost of sales (food and drink): £18,000

(£18,000 ÷ £50,000) × 100 = 36%

So 36p of every £1 of revenue goes on direct costs, leaving 64p for wages, overheads and profit.

A lower percentage isn't automatically better. It depends entirely on your business model. A high-volume, low-margin retailer can be very profitable with a high cost of sales percentage, while a low-volume luxury seller might run a much lower one. The useful comparison is against your own past figures and what you know about your own sector, not a generic benchmark.

How do you calculate gross profit from cost of sales? {#gross-profit}

Gross profit is one of the most important numbers in your accounts, and cost of sales is the input you need to find it.

Gross profit = Sales revenue − Cost of sales

The steps:

1. Work out your total sales revenue for the period.
2. Work out your cost of sales using the right formula for your business.
3. Subtract cost of sales from revenue.

Illustrative example: an independent bookshop in March

• Sales revenue: £28,000
• Opening stock: £12,000
• Book purchases in March: £15,000
• Closing stock: £10,000

Cost of sales: £12,000 + £15,000 − £10,000 = £17,000

Gross profit: £28,000 − £17,000 = £11,000

Gross profit margin: (£11,000 ÷ £28,000) × 100 = 39.3%

So the bookshop keeps just over 39p of every £1 of sales to cover rent, staff, utilities and profit.

How can I reduce my cost of sales? {#reduce-cost-of-sales}

Bringing your cost of sales down without hurting quality can lift your profit noticeably. A few practical levers:

Negotiate better supplier terms

• Get competitive quotes on materials
• Build relationships that earn volume discounts
• Ask for extended payment terms to ease cash flow
• Buy in bulk where it makes sense for fast-moving items

Improve operational efficiency

• Cut waste in production or service delivery
• Streamline processes so they use less labour time
• Train staff to lift productivity
• Tighten quality control to reduce rework

Manage inventory better

• Order closer to need to reduce storage costs
• Improve stock control to avoid obsolescence
• Focus on the products with the best margins
• Drop slow movers that tie up cash

Price strategically

Raising prices isn't a cost cut, but it does the same job for your margin and is often easier than squeezing suppliers. Plenty of businesses underprice.

One word of caution: don't chase savings at the expense of quality or service. Unhappy customers cost more than the savings you'll make.

Want a clear view of your numbers?

If your cost of sales and gross margin never quite add up, that's usually a bookkeeping problem worth fixing early. Zmartly's UK accountants keep your stock, purchases and margins accurate so you always know what each sale really earns. Book a free 20-minute call with a Zmartly accountant and we'll talk it through.

FAQs {#faqs}

What is cost of sales in simple terms?

Cost of sales is the direct cost your business incurs to produce or acquire what it sells. It covers things like stock purchases, raw materials and production labour, but not general running costs such as rent or marketing. For a bakery it's the ingredients; for a retailer it's the wholesale cost of the goods.

How do you calculate cost of sales?

For retailers: opening stock + purchases − closing stock. For manufacturers, add direct materials, direct labour and manufacturing overheads to opening stock, then subtract closing stock. For service businesses, include subcontractor costs and materials used on client work. The formula varies by business type but always focuses on direct costs.

What's the difference between cost of sales and expenses?

Cost of sales is the direct cost of producing what you sell, such as stock, materials and production labour. Operating expenses are the indirect costs of running the business, such as rent, marketing and admin salaries. Both reduce profit, but they're shown separately on the income statement so you can see gross profit before overheads.

Is cost of sales the same as cost of goods sold?

Yes. Cost of sales and cost of goods sold (COGS) mean the same thing and are used interchangeably. COGS is more common in retail and manufacturing, while cost of sales is the broader term that also suits service businesses. Both appear identically on the income statement.

Does cost of sales include VAT?

If you're VAT registered, record purchases net of VAT, because you reclaim the VAT you pay suppliers, so it isn't a real cost to you. If you're not VAT registered, you can't reclaim it, so the VAT becomes part of your cost. Whichever applies, record figures consistently throughout your accounts.

Can cost of sales be zero?

Yes. Some businesses have little or no cost of sales. Professional service firms whose staff are salaried (rather than subcontracted) often have minimal cost of sales, because their main cost is employee salaries, which are operating expenses rather than direct costs.

Does cost of sales include shipping?

It depends. Inbound freight, the cost of getting stock or materials to you, is part of cost of sales because it's needed to acquire what you sell. Outbound freight, delivering orders to customers, may be treated as cost of sales or as an operating expense depending on your accounting policy. Be consistent.

Where does cost of sales appear on financial statements?

On the income statement (profit and loss account), immediately below revenue. The format is revenue, minus cost of sales, equals gross profit. It doesn't appear on the balance sheet, although related items such as stock do.