Before reading about the differences between Cost of Sales and Overheads, it’s best to know why it is a good thing to separate them. By splitting your business’s costs into Cost of Sales and into Overheads, you can work out which of your products or services are profitable. If your most profitable products or services are not selling well, it may be worthwhile spending some money on marketing them. Conversely, if you discover that your best sellers are not making much money (or even losing money!), you will have the opportunity to do something about it.
Your income, less your cost of sales, gives you your business’s gross profit. Cost of sales are also known as Cost of Goods Sold or Direct Costs. They are called direct costs because they are directly associated to the way in which your business generates its profits (i.e. the products or services that you sell).
Examples of cost of sales include raw materials used in manufacturing, labour used to produce the goods that you sell, any goods that you buy in order to resell and their associated transportation costs. Your cost of sales is likely to change each month, sometimes substantially. For example, raw material prices can fluctuate (either in your favour – a decrease, or not in your favour – an increase).
If you calculate your business’s cost of sales as a percentage of its income and you know the ‘standard’ cost of sales percentage for your industry, you have a good tool for measuring the performance of your business. You can lower the percentage cost of sales, thereby improving your business’s gross profit, by either increasing your selling prices or reducing your cost of sales.
Overheads are also known as Indirect Costs because they are not directly associated to the way in which the business generates its profits (i.e. the products or services that it sells). Most businesses tend to try to minimise their overheads, especially when times are tough – marketing being the prime example. That is not necessarily a good thing, but maybe that’s a topic for a future article…….
Overheads include bookkeeping, marketing, telephone charges, water and electricity costs, business travel and your business’s rent payable. Overheads are taken away from your business’ gross profit in order to reach the profit on which your business’s tax is calculated.
As a business owner, it is vital that you include a contribution to overheads when costing your business’s products and services. Otherwise, your products or services can make an attractive gross profit but it is eaten away by your overheads, potentially to the stage where your business is making a loss.
Making sense? The question that you should ask yourself when deciding if an expense is a cost of sale or an overhead is “Does the expense help to generate profit for the business?” If it does, then it is a cost of sale, otherwise it is an overhead.
By starting to separate your business’s costs into cost of sales and overheads, you will start to understand your costs better and be in a position to know which you need to take more care in controlling. You only need to list your overheads and your cost of sales once and your bookkeeper will ensure that your monthly management accounts correctly portray them.
Please feel free to add your comments! Thanks. Ian Blackburn.