Cost of Sales – Various Formats
Many business owners misunderstand the use of term ‘Cost of Sales’ by restricting it to just simply ‘Cost of Goods Sold’. Basically, most business entrepreneurs and even accountants don’t realize that it has several different names and presentation formats. But it is essentially costs of sales. Cost of Sales is the generic term used. However, it is better to use the correct term based on your respective industry. The following is a short list:
Cost of Goods Sold – usually a retail industry term
Cost of Services Rendered – associated with the service or labor based businesses
Cost of Meals Served – customarily used in the restaurant and catering industry
Cost of Departmental Operations – hotels, resorts, and other multi-faceted operations
Cost of Construction – term is used with residential, commercial, industrial, shipyards and site developers
You don’t need to limit this section of the profit and loss statement to just Cost of Goods Sold or even Cost of Sales. You identify its name based on your particular primary source of sales. Remember, this section is located right after the upper part of the profit and loss statement (income statement) as illustrated here:
Returns & Allowances ZZ,ZZZ
Net Sales ZZZ,ZZZ
Other Revenues ZZ,ZZZ
Total Revenues ZZZ,ZZZ
Cost of Sales:
Labor Taxes/Benefits ZZ,ZZZ
Total Cost of Sales ZZZ,ZZZ
Gross Margin ZZZ,ZZZ
Instead of ‘Cost of Sales’, depending on the nature of your primary purpose, change the name to a more suitable identifier or format. Remember, this is YOUR financial report. Generally Accepted Accounting Principles has a prescribed presentation requirement for publicly traded operations, but your business isn’t publicly traded. There are no P&L Cops out there to get you. You are not going to get arrested, nor fined, nor even a glaring look from anyone. Give this section an appropriate name based on your industry so that any common person reading this report understands what you do in business.
The following sections describe some of the more common names and where they are applied. I even give a simple presentation format for the respective sections so you can compare and use the format that best suits your needs. Remember, financial reports are used by the owner to better understand their business operation and for analysis purposes. It acts as a critical point in the feedback loop of information so the owner can make decisions to better improve his operation.
Cost of Goods Sold
This is by far the most commonly used format by most businesses. This term works appropriately for retail and manufacturing but not so much for other industries. It has several different presentation formats including inventory presentation formats. The following are some examples of this section of the profit and loss statement:
- Limited Labor Retail Establishments – such as vending machine operators or auto parts stores
Cost of Goods Sold:
Beginning Inventory $ZZZ,ZZZ
Less Returns/Allowances ( ZZ,ZZZ)
Less Ending Inventory ZZZ,ZZZ
Cost of Goods Sold $ZZZ,ZZZ
- Specific Identification Retail – this method works well with appliance outlets, heavy equipment retail, large tool sellers, jewelers, and electronic outlets
Cost of Goods Sold (Specific Identification Method):
Direct Cost of Items Sold $Z,ZZZ,ZZZ
Warranty Fees ZZ,ZZZ
Cost of Goods Sold $Z,ZZZ,ZZZ
Cost of Goods Sold (Manufactured):
Raw Resources –
Beginning Inventory $ZZ,ZZZ
Ending Inventory (ZZ,ZZZ)
Raw Resources Consumed By Plant $ZZZ,ZZZ
Plant Labor $ZZZ,ZZZ
Plant Management ZZ,ZZZ
Sub-Total Plant Labor ZZZ,ZZZ
Equipment Utilization ZZ,ZZZ
Equipment Rent/Leases ZZ,ZZZ
Cost of Goods Sold (Manufactured) $ZZZ,ZZZ
Notice how the manufacturing presentation format is a multiple step process? This relates to the function of taking raw resources and direct labor and producing a product that is sold to the retail industry. Not only can the cost of goods sold exist in a simple mathematical equation like the general retail format, it can get highly convoluted for more advanced operations. There is no one single format that works for everyone. The following section illustrates this with service based operations.
Cost of Services Rendered
In the labor intensive industries, the cost associated with those services are predominately labor based and not oriented towards materials like the ‘Cost of Goods Sold’ section. The best examples of industries using this form of presentation are your service based industries: nursing care, cleaning services, auto repair facilities, professional services (lawyers, accountants, and engineers), carpet cleaners and medical practices.
In providing service, the primary cost is of course the staff that provides the direct service. A good presentation format lists the higher paid professionals first and the auxiliary support staff as the secondary line of data. In addition, whenever identifying the salaries, a service based operation should also include in a separate line the cost of taxes and benefits. Some organizations will separate the legally required benefits from the voluntary based benefits. The following cost of goods sold section reflects a professional services office such as a law firm:
Cost of Services Rendered:
Licensed Professional Salaries $ZZ,ZZZ
Support Staff ZZ,ZZZ
Taxes & Benefits ZZ,ZZZ
Direct Cost of Services $ZZ,ZZZ
Reimbursed Expenses Z,ZZZ
Total Cost of Services Rendered $ZZ,ZZZ
Notice that in the example above the practice separated the salaries from other types of non-payroll costs. It is not uncommon for a professional based organization to reimburse the staff for such items as auto mileage, copying fees, communications and fees. The client is usually charged these fees and so there is a revenue line designated as Reimbursed Expenses.
In most service based operations, the organization uses the service to repair or maintain equipment or real estate. Examples include the mechanical based trades, auto service shops and lawn service companies. Their respective cost of services rendered section will include the corresponding costs of parts. The following is an example from an auto repair facility:
Cost of Services Rendered:
Mechanics Wages/Salaries $ZZ,ZZZ
Parts & Supplies Z,ZZZ
Sublets (Outside Services) Z,ZZZ *Towing, Machine Shops, Body Repair, Welding
Total Cost of Services Rendered $ZZ,ZZZ
Just as similar to professionals, mechanics often attend training. Why isn’t training one of the lines? Well, in the professional license situation, it is required by law; in the auto trades industry it is highly encouraged. This means that in the auto repair financial reporting, training is customarily an overhead expense. However, as the owner of a repair shop, you may place it in the cost of services rendered, but be consistent from year to year.
An often asked question relates to the owner of the company. It is normal for the owner to work and provide services too. You see in the medical profession and in the professional services industry. Where do we put their respective earnings? Where the predominant time of the owner is spent should be the location of his/her compensation. In the medical practice, it is obviously in the costs of services section. In something like an engineering firm, usually the owner spends more time courting potential clients and marketing the business. Therefore, his compensation would be located in the overhead section of the profit and loss statement.
Cost of Meals Served
Many business owners do not realize that the purpose of the Cost of Sales section is to assist in making good management decisions. Evaluation of this section against the sales associated with costs allows for analysis and setting standards of performance. The more information in the cost section the greater the opportunity to make better decisions.
In the restaurant and catering business (Food Service), there are two primary costs that drive upwards of 50% of total costs of business. Staffing and food alone is disproportionally more significant than in other industries. The cost of sales section is formatted to provide better analysis of performance. In general, the sales section is divided into two distinct groupings of food and beverages. Each of these two groups is then further partitioned to reflect functions. In food, it is divided into entrees, appetizers and desserts. With beverages, it is generally split between Alcohol and Sodas. Often, alcohol is split between spirits and wine/beer. A typical sales section of a restaurant will look like this:
Sub-Total Food $ZZ,ZZZ
Sub-Total Beverages ZZ,ZZZ
Total Sales $ZZ,ZZZ
Therefore the Cost of Meals Served section will correlate with the sales to make analysis easy. Look at this:
Cost of Meals Served
Sub-Total Food ZZ,ZZZ
Sub-Total Beverages Z,ZZZ
Taxes/Benefits (Staff) Z,ZZZ
Sub-Total Staff Payroll ZZ,ZZZ
Total Prime Costs $ZZ,ZZZ
In the restaurant industry, they use the term ‘Prime Costs’ as a subsection of Cost of Meals Served. The Cost of Meals Served actually reflects total variable costs as this industry has one of the highest correlation of variable costs to actual sales. These variable costs in the aggregate generally exceed 65% of total costs of operations. It is essential that the Cost of Sales section is built around identifying critical expenditures related to sales. There are several articles dedicated to the format and analysis of a restaurant profit and loss statement on this website. If you want a lot of detail analysis training then I suggest reading: The Restaurant Profit and Loss Statement – Best Format to Use.
The main point is that the Cost of Sales section can be and should be modified to help the owner analyze his business operations. The restaurant’s profit and loss statement is a perfect example of a well laid out format to analyze performance.
Cost of Departmental Operations
In other industries, a vast array of services and products are provided. A good example is in the hospitality industry. Here, the cost of sales section reflects via columns the various departments of operations. Look at this example:
Cost of Departmental Operations:
Lodging Conference Center Food Service
Staff Payroll (Taxes Inclusive) $Z,ZZZ $Z,ZZZ $Z,ZZZ
Food/Beverages Z,ZZZ Z,ZZZ
Supplies Z,ZZZ ZZZ ZZZ
Outside Services ZZZ Z,ZZZ Z,ZZZ
CC Discounts ZZZ ZZZ ZZZ
Total Cost of Operations $ZZ,ZZZ $Z,ZZZ $ZZ,ZZZ
In this industry, separation of the departments allows the financial statement reviewing the opportunity to identify the better performer and any issues related to underperformance. Each department’s sales are compared to the respective costs and margins are calculated. These margins over time set the standards and any deviation from the standard is investigated to determine shortcomings.
Another industry that uses a highly complex model for cost of sales relates to construction.
Costs of Construction
This industry is different in understanding their respective cost of sales. The problem is how the money is earned. In general, the business runs projects and each project generates revenue in stages or what is commonly referred to as phases. Each phase as many different types of costs such as materials, labor and subcontractors. To make matters more complicated, the business has many costs that are spread over the projects. A good example is insurance. Insurance has a higher cost per dollar of sales than other industries due to the physical risk of not only the labor pool but the exposure the materials have to fire and weather while the project is ongoing.
To understand their cost of sales, those costs related to items that are spread over all the projects are referred to as indirect i.e. there is no way to assign them to any single project. These costs include project management salaries, transportation, tooling, insurance and communications. To exercise analysis and fully understand their cost of sales, the Costs of Construction is divided into two distinct groups. Those costs that can be directly assigned to a project are called direct and those costs that must be spread over all the ongoing projects are referred to as indirect. The following is an example of a residential contractor’s cost of sales section in the profit and loss statement:
Costs of Construction
Sub-Total Direct Costs $ZZ,ZZZ
Project Management Z,ZZZ
Sub-Total Indirect Costs ZZ,ZZZ
Total Costs of Construction $ZZ,ZZZ
I have written extensively on this format. If you desire to understand more, then read: Profit and Loss Statement – Construction Industry.
This format is designed to benefit the owner in understanding the volume of construction needed to offset his indirect costs of construction. Think of it kinda like a variable and fixed separation of costs related to this industry.
The following section provides a summation and some suggestions for you if want to modify your financial profit and loss statement.
I hope I convinced you that first off, the profit and loss statement is YOUR REPORT. Customize it to suit your needs. The above various examples illustrate that there is no correct way of doing this. Build a model and call the cost of sales section a name that any common layman will understand what you do. If you are involved in transportation, then call this section ‘Costs of Transportation’. Drive the respective lines of information based on the highest cost as the primary line and so on until you exhaust the major groups of costs.
In some industries, management is more involved in the day-to-day operations and therefore you’ll need to divide the Cost of Sales section into two distinct groups of direct and indirect costs. But there is no single correct way you must follow. Lay it out in a way that you understand what is going on with your business.
There are problems related to using computerized software. A good example is QuickBooks. The designer and owner of QuickBooks, Intuit, hasn’t modified their software to allow the user the ability to change the name of this group of costs. You would think that they could understand this basic concept of accounting; but they call it the traditional Cost of Goods Sold and therefore you can’t change it. However, you can export the information to a spreadsheet and change the name there! That is how I do it for several clients and it is easy and I can format the information for the owner to easily evaluate his operation.
I urge you as an owner to customize this section of the income statement (profit and loss statement) to suit your needs. Gain a better understanding of what it really costs to operate and you’ll discover opportunities to better increase your profit. If you have any comments or questions, e-mail me at dave (insert the usual symbol) businessecon.org. I would love to hear from you. Act on Knowledge.
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