What belongs in cost of sales, and what doesn't
Which costs belong in cost of sales and which are operating expenses, why the split changes your gross margin, and how the till posts cost of sales.
By Achekam · · 4 min read · For Running a business businesses in South Africa, Nigeria, Kenya
Two businesses sell the same goods at the same prices and spend the same in total. One reports a healthy gross margin and heavy overheads; the other reports a thin gross margin and lean overheads. The difference is not performance. It is where each bookkeeper chose to put the freight, the warehouse wages and the packaging.
Gross margin is the figure owners, lenders and buyers of businesses look at first, because it shows what each sale really earns before the cost of running the place. If cost of sales is a mixed bag, that figure means nothing, and month-to-month comparisons mean even less. Getting the line in the right place is a one-off decision that pays back every month.
Direct costs of what you sold
Investopedia defines cost of goods sold (COGS) as the direct costs of manufacturing or purchasing the products a business sells, leaving out indirect costs such as distribution and the sales force. It notes that the term is also referred to as cost of sales, although it later explains a subtle difference between the two. For a small business, treat them as the same line.
Investopedia lists what is typically included:
- direct materials;
- direct labour;
- manufacturing overhead;
- freight and shipping costs to bring goods in (but not the cost of shipping products to customers);
- other direct production costs.
It also explains that the direct costs include direct labour and the cost of materials used to make the products. For a reseller, that is mainly the purchase price of the goods. For a manufacturer, it is materials, the wages of people who make the product, and the factory costs that support production.
Freight in, but not delivery to customers
The freight rule is the one most often got wrong, and Investopedia draws the line clearly: the cost of bringing goods to you belongs in cost of sales; the cost of shipping products to customers does not.
| Cost | Where it goes | Why |
|---|---|---|
| Courier bringing stock from the supplier | Cost of sales | Part of what the goods cost you to have ready for sale |
| Freight on imported stock for resale | Cost of sales | As above |
| Delivery van taking orders to customers | Operating expense | Distribution, after the goods are sold |
| Postage on customer orders | Operating expense | Distribution |
Rent, marketing and administration below the line
Investopedia explains that operating expenses such as rent, utilities, office supplies, legal costs, sales and marketing, payroll and insurance are not directly tied to production and are reported separately from cost of goods sold. They sit below the gross profit line. The wages of people who actually make the product are the exception: as direct labour, they belong in cost of sales.
The test for any cost is simple: would it rise if you sold one more unit? The materials in that unit would; the office rent would not. Grey areas, such as factory rent or a workshop supervisor's salary, depend on whether you treat production overhead as part of cost of sales. Pick one approach, write it down, and apply it every month.
Costs of goods not yet sold
Investopedia explains that costs incurred on goods not sold during the year are not included in that year's cost of goods sold. They sit in inventory until the goods are sold.
ACCA sets out the arithmetic: cost of sales is opening inventory plus purchases minus closing inventory. Closing inventory is therefore a credit to cost of sales in profit or loss and a current asset on the balance sheet. A business that buys a large shipment just before year-end and charges it all to cost of sales understates its profit and its assets, unless the closing stock count puts the unsold part back.
Accounts in Achekam's chart, and the till's posting
Each business on Achekam has its own double-entry ledger with a standard chart of accounts created when the books first open. Accounts can be added, renamed or switched off, so you can add separate cost of sales accounts for, say, freight in and packaging if you want to see them on their own.
For businesses with the till, cost of sales posts itself. Every till sale that reaches the server posts a balanced journal in the same step, with revenue, output VAT, the payment method, and cost of sales against inventory at the product's cost price. In the standard chart, cost of sales is 5000 or 5100 and inventory is 1300. Gross margin on till sales is therefore visible in the management accounts, which show an income statement for a chosen period beside the period before.
Three limits shape how far you can rely on that:
- One cost price per product. Cost of sales uses the single cost price typed on the product, with no FIFO or weighted-average costing. If your buying price changes, the till's cost of sales does not follow it.
- Invoices do not post cost of sales. Customer invoice lines are typed in and cannot be picked from the product list, so invoices do not move stock or post cost of sales. A business that sells goods on invoice needs a cost of sales journal for those sales.
- Stock movements outside the till stay off the ledger. Stock counts, wastage, transfers and opening quantities do not post to the general ledger; only till sales and till returns move the inventory account. Your accountant will adjust inventory and cost of sales to the counted stock at month-end or year-end.
Industry examples help: see gross margin from till sales and direct labour in a consulting firm's gross margin.
Next step
Investopedia's article on cost of goods sold and how it is calculated explains what it includes and the methods used to value it. List every expense account in your chart, mark each as cost of sales or operating expense using the test above, and ask your accountant to move any that sit on the wrong side.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
