Understanding Gross Margin and Cost of Sales

The slight difference between the cost of sales and COGS is that it also includes the costs of services provided, making it more relevant to service-oriented businesses. A consultancy, for instance, would have the cost of sales that might consist of the salary of consultants and direct expenses to provide their services, such as travel when visiting clients. Service-based businesses have the same need to understand how profitable they are by project, by client, and by service line. So they typically track work effort (hours and dollars spent) at that granular level of detail, then precisely allocate labor costs to COS at that same level of detail. Sophisticated professional service agencies also match the timing between service revenue and corresponding labor costs using accrual-basis accounting methodology. Both COGS and cost of sales directly affect a company’s gross profit.

While the cost of sales isn’t deductible, you can subtract COGS from gross receipts to calculate a company’s annual gross profit. Claim COGS and other business expenses to boost tax deductions while limiting profit. But what’s the point of spending so much time examining sales costs? Recognizing how to calculate the cost of sales is essential for calculating your company’s gross profit. Your overall gross margin gives you a general idea of the production costs in relation to your revenue.

What is included in the cost of sales?

Airlines provide food and beverages to passengers, and hotels might sell souvenirs and spa products. There are some wildcards here – for example, some businesses consider fulfilment costs to be part of COGS while others consider them selling costs. They’re the gap between gaap and non direct costs either way, so regardless of where you classify them on the P&L it’s important to consider those costs in your contribution margin analysis. In accounting, the acronym COS could indicate either cost of sales or cost of services.

Gross margin is the amount left after deducting the Cost of Sales from the total revenue. All this extra work gives an accurate read on where the company’s profit is really coming from – and where the firm might actually be losing money. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. Niko is a CFO and a financial advisor who is passionate about solving problems, data analysis, mentoring smart entrepreneurs and bringing clarity and focus in difficult situations.

Cost of sales vs. cost of goods sold

The income statement starts with the company’s total revenue or sales for the period. Then, COGS is subtracted from this total revenue to calculate the gross profit. Cost of sales and COGS are key metrics in analyzing business profitability. Both show the operation costs involved in producing goods or services. If these costs are rising while revenue isn’t, this could indicate that direct costs are not being managed properly. Because service-only businesses don’t base operating expenses on tangible goods, they cannot list COGS on their income statements.

1. So they typically track work effort (hours and dollars spent) at that granular level of detail, then precisely allocate labor costs to COS at that same level of detail.
2. For example, a manufacturer like a toy company would have COGS that include the cost of plastic and other materials used in manufacturing, as well as the wages of factory workers.
3. If COGS or the cost of sales increases without adjusting prices, the company might face reduced margins.

These costs include labor, raw materials, and overhead directly tied to production. Instead, the companies will show the words cost of sales and/or cost of services. For example, the income statements of Apple and Intuit report both cost of products and cost of services.

Examples of businesses that would do so are attorneys, business consultants, and doctors. COGS tracks the direct costs tied to the production of a company’s goods. This includes the materials and labor directly used to create the product but excludes indirect expenses such as marketing, distribution, and sales. The cost of sales accounts for only the production costs of goods (or services) sold.

It’s often a pivotal metric to make or break a successful equity capital raise or bank debt negotiation because it determines how much profit is generated from each new dollar of sales revenue. Once you recognize your gross https://www.kelleysbookkeeping.com/your-third-stimulus-check-can-be-seized-here-s/ profit, you can evaluate how well you operate the production process and how much remaining income you’ll have to manage with other expenses. Some service providers, however, also offer secondary products to customers.

COGS & COS: How are They Calculated and Why Does it Matter?

Because you use them frequently interchangeably, it can be difficult to tell how they’re different. That is once you understand what to include and exclude from the equation. COS can be valuable for product managers looking to implement the correct product roadmap tools. For example, a manufacturer like a toy company would have COGS that include the cost of plastic and other materials used in manufacturing, as well as the wages of factory workers.

Companies that offer goods and services are likely to have both COGS and cost of sales on their income statements. COGS can also include “tricky bits” such as consumable parts used in the production process along with factory overhead and labor costs. Those should all be allocated on a per-unit basis whenever possible. It is because cost of sales includes other charges whereas COGS concentrates on a company’s direct costs. On an income statement, cost of sales comes before EBIT margin (operating earnings over operating sales).

It means that your COS should only take up 10-20% of your total revenue. In all cases, gross profit (GP) is simply the profit remaining after subtracting COGS or COS from revenue. Gross margin (GM) is the percentage you get when you divide GP by revenue. GM is a critical metric for most scaling businesses to budget around.