Cost of Sales is a special type of expense that is used to differentiate between the direct costs and general overhead expenses of a business. It is important to determine the correct Cost of Sales to ensure pricing of products or services are established at levels that provide an appropriate gross profit margin and put the business in position to maximize profitability by managing overhead expenses. Items most commonly included in Cost of Sales are direct labor, direct materials, and overhead allocations.
Direct labor is exactly what its name implies: the costs of all employees and contractors that provide services to customers or create products sold to customers. This includes wages, payroll taxes, benefits such as medical or dental insurance, and any other benefits provided to employees. Basically, any cost associated with compensating and retaining employees directly involved in performing services or producing products is included in direct labor.
Direct materials also reflect easily identifiable resources in retail or production businesses. The cost of the materials that go into creating an inventory piece is considered direct materials. These costs are accumulated to determine the inventory value and are not usually shown separately from the inventory item. However, in a service business that bills based on time and materials, those materials would be included in direct materials.
Overhead allocation can include several different items depending on the business and its industry. One typical allocation is the cost of managers that supervise direct labor employees. These managers may not work on the products directly, but are essential to production and delivery of products and services. Another example of overhead allocation is merchant fees, which are also a direct variable cost associated with specific sales transactions. Travel can also be allocated as a direct cost if employees are traveling for specific client projects in a service business. Basically, overhead allocation items are determined as any costs directly related to generating revenue. These are not to be confused with sales and marketing costs, which relate to brand awareness and customer acquisition and are not included in Cost of Sales.
Cost of Sales are variable costs associated with generating revenue. If costs are allocated incorrectly, it makes it difficult to properly price products and services. If pricing is too high, competitive advantage erodes; if pricing is too low, gross profit margin will suffer. The professionals at TGG Accounting are experienced in assisting businesses in developing direct cost models that are accurate and complete, resulting in consistently stronger gross profit margins.Written by: Ashley Peth TGG Accounting