Accounting for Entrepreneurs

Understanding and Computing the Cost of Sales

Written by Samuel Muriithi for Gaebler Ventures

In order for you to make a useful estimation of the profits to expect out of a business activity you need to establish the costs you'll incur in making sales. It is these expenses that are incurred in bringing a product/service to the market that are referred to as the cost of sales.

Before you can offer a certain product or service to the market you have to incur some sort of expense in acquiring it.

This expense is what is referred to as cost of sales. For example, a butcher can spend $500 to purchase a corresponding quantity of beef from which he will then make sales totaling $750. His cost of sales in this case is $500, his sales amount to $750, and the difference of the two i.e. $250 is his gross profit. The gross profit thus earned is the sum of money from which he can deduct his operating expenses including transportation, salaries, rent etc. The remainder is what he has actually earned for himself i.e. the net profit.

Computing the cost of sales is not normally as straightforward as the illustration above will have you think. There are generally three categories of expenses that you must take into consideration before arriving at your cost of sales. These are:

The cost of materials - This is the amount of money you will have used to purchase all the materials you require to put together a product or service.

The cost of labor - This is the amount of money payable to all those who have been directly involved in putting the product or service together. This expense should also cover the time you have spent on the activity if you were directly involved in the product/service assembly.

The overheads - These are the costs you incur as payment for the utilities and general costs that you use in producing a product/service. In computing the cost of sales you should not factor in expenses that were not inherently incurred for particular products or services. For example, if you used a vehicle to transport some components of a certain product and you ended up using one-third of the total volume of fuel it is this amount that you should indicate and not the entire fueling cost.

Having taken into account all these costs you are now in a position to make an informed estimate as to what price you can charge for the product or service. That price should cover your cost of sales and the other general expenses (operating expenses) your business incurs, and still be sufficient to earn you a good profit.

Samuel Muriithi is a business owner in Nairobi, Kenya. He has extensive international business experience in the United States and India.

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