Cost of Sales (COS) is a crucial revenue metric that reveals the direct costs associated with the products a company sells. Particularly used by retail or wholesale companies, it shows the amount these companies invest in purchasing products from suppliers for the purpose of resale.
Unlike manufacturers, who typically use the Cost of Goods Sold (COGS) metric, companies that rely on purchasing products from external suppliers rely on the COS metric to gain visibility into their spending.
Key Takeaways
- Definition: Cost of sales (COS) represents the direct costs associated with obtaining products for resale, and is commonly used by retail and wholesale companies.
- Calculation: COS is calculated using the formula: Beginning inventory + purchases + additional direct costs – ending inventory.
- Strategic Importance: Understanding COS is fundamental to profit calculation, setting pricing strategies, future budgeting and forecasting, operational efficiency, and performance analysis.
- Optimization Strategies: Effective negotiation with suppliers, bulk purchasing, efficient inventory management, monitoring additional direct costs, and regular review of supplier contracts can help optimize COS.
- Limitations: COS doesn’t reflect indirect costs, can be affected by inventory valuation methods, doesn’t differentiate between product lines, doesn’t provide insight into sales volume, is subject to supplier price fluctuations, doesn’t indicate sales performance, and lacks context without complementary metrics.
- Complementary Metrics: COS should be evaluated alongside metrics such as gross profit margin, operating expenses, and inventory turns for a complete understanding of business performance.
Why does Cost of Sales matter for your business?
Grasping the Cost of Sales has manifold benefits for a business:
- Profit Calculation: The primary advantage of tracking COS is to compute the gross profit by subtracting the COS from the total revenue. This gross profit figure offers insights into the fundamental profitability of the business operations.
- Pricing Strategy: Understanding COS aids in setting competitive pricing strategies. By determining how much it costs to obtain a product, businesses can set a sale price that ensures profitability while remaining attractive to customers.
- Budgeting and Forecasting: COS provides insights for future budgeting and forecasting. By tracking trends in the COS, businesses can predict future expenses and strategize accordingly.
- Operational Efficiency: A constant monitoring of COS can highlight areas of inefficiency or wastage, allowing businesses to make necessary adjustments to their purchasing or supply chain processes.
- Performance Analysis: By comparing COS with industry benchmarks, businesses can gauge their performance and identify areas of improvement.
How to calculate Cost of Sales (COS)?
Explanation of the parts of the formula:
- COS (Cost of Sales) represents the direct costs attributable to the production or procurement of the goods sold by a company. This includes the cost of the materials used in creating the goods along with the direct labor costs used to produce the goods.
- Beginning Inventory is the recorded cost of inventory at the beginning of an accounting period. It is the residual value of inventory at the end of the previous accounting period.
- Purchases are the additional inventory that a company bought during the current accounting period.
- Additional Direct Costs are any other costs that are directly tied to the production or procurement of inventory during the current accounting period. This may include costs like direct labor or shipping costs.
- Ending Inventory is the remaining unsold inventory at the end of the accounting period.
In essence, the Cost of Sales measures how much a company has spent to produce or procure the goods that it has sold during an accounting period. This is important as it helps to determine gross margin and is a key input in the calculation of net profit.
Example Scenario
Imagine that at the start of January:
- Your beginning inventory was valued at $5,000.
- During January, you purchased an additional $3,000 worth of inventory.
- You had additional direct costs of $500.
- At the end of January, you had $2,000 worth of unsold inventory.
Insert the numbers from the example scenario into the above formula:
- COS = Beginning Inventory + Purchases + Additional Direct Costs – Ending Inventory
- COS = $5,000 + $3,000 + $500 – $2,000
- COS = $6,500
This means that your cost of sales for January was $6,500.
Tips and recommendations for reducing Cost of Sales
Negotiate with suppliers
Establishing a mutually beneficial relationship with suppliers is paramount to reducing the cost of sales (COS). The relationship built over time paves the way for negotiating prices and terms. This can range from volume discounts to more favorable payment terms, all of which can potentially reduce COS. In addition, suppliers can provide early access to new products, which can provide a competitive advantage and indirectly impact the COS by increasing sales.
Bulk purchasing
Bulk purchasing is another strategy for improving COS. When companies order items in larger quantities, they often receive volume discounts that effectively reduce the unit cost of products. However, it’s important to balance this approach with demand forecasting to avoid unnecessary inventory buildup. While bulk purchasing reduces unit costs, it must be carefully managed to avoid excessive inventory carrying costs and potential waste for perishable goods.
Inventory management
Effective inventory management is a critical component of COS optimization. It involves maintaining just the right amount of inventory to meet customer demand without overstocking. This allows companies to minimize inventory carrying costs and avoid tying up capital in unsold merchandise. In addition, efficient inventory management prevents out-of-stocks and ensures that sales opportunities are not missed due to lack of stock availability.
Monitor additional direct costs
Keeping an eye on additional direct costs, such as shipping or duties, is essential to managing COS. These costs can add up significantly and have a direct impact on the final cost of the product. By finding alternative solutions or suppliers that offer better shipping rates or customs clearance services, companies can reduce these ancillary costs. It’s also worth exploring options such as local sourcing or consolidating shipments to further optimize these costs.
Review supplier contracts regularly
Finally, regular review of supplier contracts is a useful COS management practice. This activity involves continually evaluating the pricing terms, product quality, delivery reliability, and service levels offered by suppliers. If necessary, contracts should be renegotiated to ensure that the company is always getting the best possible deal. This proactive approach not only helps control costs, but also ensures that supply chain performance aligns with the evolving needs of the business and market conditions.
Examples of use
Dynamic Pricing Models
- Scenario: An online clothing retailer notices fluctuations in the COS due to seasonal changes in supplier prices.
- Use Case Application: The retailer can implement a dynamic pricing model, adjusting prices based on the current COS. This ensures that profit margins remain consistent, regardless of seasonal shifts in costs.
Strategic Supplier Partnerships
- Scenario: A bookstore finds its COS is increasing due to rising paper costs.
- Use Case Application: The bookstore can establish a strategic partnership with a paper supplier to lock in prices or receive volume discounts, thereby mitigating the rise in COS.
Inventory Optimization Techniques
- Scenario: A tech store realizes it consistently has excess stock of certain items, resulting in high holding costs.
- Use Case Application: By analyzing sales data and implementing an inventory optimization system, the store can reduce unnecessary stock, ultimately reducing its COS.
Alternative Product Sourcing
- Scenario: A gourmet restaurant sees an increase in the COS for certain imported ingredients due to global supply chain disruptions.
- Use Case Application: The restaurant can explore sourcing similar high-quality ingredients locally or from alternative regions, ensuring menu quality while decreasing COS.
Diversification of Suppliers
- Scenario: A cosmetics retailer is reliant on a single supplier for a popular product, which has increased its prices.
- Use Case Application: By diversifying and adding more suppliers, the retailer can leverage competitive pricing and reduce dependency on one source, stabilizing the COS.
Cost of Sales SMART goal example
Specific – 30% reduction in cost of sales (COS) (approximately $150,000 per month).
Measurable – COS will be tracked and compared before and after implementing cost reduction measures.
Achievable – Yes, by optimizing supplier contracts, improving inventory management, reducing waste, and implementing production efficiency measures.
Relevant – Yes. This goal aligns with the company’s goal to increase profitability by reducing costs, with a target of approximately EUR 150,000 per month in the next fiscal year.
Timed – To be achieved within one year of initiating cost reduction measures.
Limitations of using Cost of Sales
While the Cost of Sales (COS) is a critical metric for understanding the direct costs associated with the goods sold by an ecommerce business, it has its limitations when used in business analysis:
- Doesn’t Reflect Indirect Costs: COS only accounts for the direct costs of producing the goods sold. It doesn’t include indirect expenses like marketing, administration, or distribution costs which can significantly impact profitability.
- Can Be Influenced by Inventory Valuation Methods: The method used to value inventory (e.g., FIFO, LIFO, or average cost) can greatly affect the COS, potentially giving a distorted view of cost efficiency. For instance, in times of rising prices, using FIFO might show a lower COS compared to LIFO.
- Doesn’t Differentiate Between Product Lines: COS doesn’t specify which product lines are more cost-effective. If certain products have higher costs but don’t contribute significantly to revenue, they could be dragging down overall profitability.
- No Insight into Sales Volume: A low COS is beneficial, but if sales volumes are also low, it might not yield a profitable operation. The relationship between sales volume and COS is crucial to understanding profitability.
- Subject to Fluctuations in Supplier Pricing: COS can vary based on changes in supplier pricing or availability of raw materials. It’s important to monitor these external factors as they can impact COS significantly.
- Not Indicative of Sales Performance: A lower COS doesn’t necessarily mean higher sales performance. If sales are low or customer retention is poor, a low COS won’t guarantee business success.
- Overemphasis Can Lead to Neglecting Other Metrics: While trying to decrease COS, businesses might overlook other essential metrics like customer acquisition cost (CAC), lifetime value (LTV), or conversion rates. A holistic view is key.
- Lacks Context Without Additional Metrics: COS in isolation doesn’t provide a full picture. For example, a high COS might be concerning, but if the business has high sales volumes and strong customer loyalty, it might not be as problematic.
In summary, while COS is a valuable metric in the mix of e-commerce KPIs, it should be used in conjunction with other metrics to gain a comprehensive understanding of a company’s performance. It shouldn’t be the only metric used to make strategic decisions.
KPIs and metrics relevant to Cost of Sales
- Gross Profit Margin: This is the ratio of gross profit to total sales revenue. It offers insights into how efficiently a business is producing or sourcing its goods.
- Operating Expenses: These are the indirect costs of running a business. Together with COS, they provide a more comprehensive view of total business costs.
- Inventory Turnover: This metric shows how often inventory is sold and replaced in a given period. A higher turnover rate can indicate efficient sales and inventory management.
By closely monitoring COS and integrating it with other key metrics, your company can maintain profitability and ensure sustainable growth.
Final thoughts
Cost of sales (COS) is a fundamental metric for retail and wholesale organizations. By effectively tracking and optimizing COS, these companies can ensure that their operations remain profitable, price their products competitively, and make informed financial decisions that drive growth.
Cost of Sales (COS) FAQ
What is Cost of Sales (COS)?
COS represents the direct costs associated with obtaining products for resale for retail and wholesale businesses.
How does COS differ from COGS?
While COS is used by businesses that buy products for resale, COGS is employed by manufacturers to track the direct costs of producing goods.
Why is monitoring COS crucial?
Understanding COS is pivotal in determining profitability, setting pricing strategies, and making informed financial decisions.
How can I reduce my COS?
Effective negotiation with suppliers, bulk purchasing, efficient inventory management, and constant monitoring of additional direct costs can help in optimizing COS.