Cost of sales is the cost of the goods or services a business actually sold in the period, and it is the line that sits between turnover and gross profit in the UK statutory profit and loss format. For a business that holds stock the basic calculation is opening stock + purchases − closing stock. What goes into it is set by FRS 102 Section 13 for inventories: costs of purchase and conversion go in, while selling costs, abnormal waste and general administration stay out.
Where cost of sales appears in the accounts
The Companies Act formats give UK companies two ways to present the profit and loss account. Format 1, the one most trading companies use, analyses expenses by function:
- Turnover;
- Cost of sales;
- Gross profit or loss;
- Distribution costs;
- Administrative expenses;
- Other operating income.
Format 2 analyses expenses by nature instead: change in stocks, raw materials and consumables, other external charges, staff costs, depreciation. It has no cost of sales or gross profit line at all, which is why a gross margin cannot be read straight off a Format 2 profit and loss account.
The regulations add one rule that is easy to miss: cost of sales, distribution costs and administrative expenses must be stated after taking into account any necessary provisions for depreciation or diminution in value of assets. Depreciation on production machinery therefore belongs in cost of sales, not in a separate line below gross profit.
Small companies can currently go further. With the consent of all members, the directors may draw up an abridged profit and loss account that combines turnover, cost of sales, gross profit and other operating income into a single "Gross profit or loss" line. And a small company that files filleted accounts does not put its profit and loss account on the public record at all. Both options are due to end: from 1 April 2028 Companies House will no longer accept abridged accounts, and small companies and micro-entities will have to file their profit and loss account, with an option to opt out of having it published.
How to calculate it
For a business that carries stock, cost of sales is the purchase cost adjusted for the change in stock:
| Illustration (invented figures) | £ |
|---|---|
| Opening stock | 40,000 |
| Add purchases in the year | 300,000 |
| Less closing stock | (60,000) |
| Cost of sales | 280,000 |
| Turnover | 500,000 |
| Gross profit | 220,000 |
| Gross margin | 44% |
The closing stock figure is doing a lot of work. Every pound of overstated closing stock is a pound of understated cost of sales and overstated profit, which is why stock counts and valuation get so much attention at the year end, both from auditors and from HMRC.
What goes in: the FRS 102 rules
FRS 102 paragraph 13.20 says that when inventories are sold, their carrying amount is recognised as an expense in the period in which the related revenue is recognised. So the content of cost of sales is driven by what the standard allows into the cost of stock. Paragraph 13.5 includes all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition:
- Costs of purchase. The purchase price, import duties and other taxes that are not recoverable (so not reclaimable VAT), and transport, handling and other directly attributable costs. Trade discounts and rebates are deducted;
- Costs of conversion. Direct labour and a systematic allocation of fixed and variable production overheads, such as depreciation and maintenance of factory buildings and equipment and the cost of factory management;
- Other costs. Only to the extent they bring the goods to their present location and condition.
Fixed production overheads are allocated on the basis of normal capacity. If a factory runs well below capacity, the unallocated overhead is expensed in the period rather than loaded onto fewer units, so idle time does not inflate stock values.
What stays out
Paragraph 13.13 lists costs that are excluded from inventories and expensed as incurred:
- Abnormal waste. Abnormal amounts of wasted materials, labour or other production costs;
- Storage. Storage costs, unless necessary in the production process before a further production stage;
- Administration. Administrative overheads that do not contribute to bringing inventories to their present location and condition;
- Selling costs. Costs of selling the goods, such as advertising, which are normally presented in distribution costs.
Two further rules shape the number. Stock is carried at the lower of cost and estimated selling price less costs to complete and sell, so a write-down of obsolete or damaged stock increases cost of sales. And interchangeable items must be costed using FIFO or weighted average; LIFO is not permitted under FRS 102.
Service businesses
Firms that sell time rather than goods still have a cost of sales, though the line is a matter of judgement. Paragraph 13.14 points the way for any work in progress: the cost consists primarily of the labour and other costs of personnel directly engaged in providing the service, including supervisory personnel, and attributable overheads. Sales and general administrative staff are excluded, as are profit margins. In practice, an agency or consultancy usually puts subcontractors and fee-earner salaries in cost of sales and office rent, finance and marketing in administrative expenses. The test is whether the cost varies with delivering the work, a distinction explained further in our guide to direct and indirect costs.
Cost of sales for sole traders
Self-employed people meet the same idea on the tax return. On the full self-employment pages (SA103F), the 2025-26 notes describe box 17, "Cost of goods bought for resale or goods used", as including raw materials, direct costs of producing goods sold, commissions and any discounts. If you use traditional accounting rather than the cash basis, you must adjust for opening and closing stock. Goods taken for private use and depreciation of equipment are disallowable, and if included they must be added back. HMRC's guidance on allowable expenses lists "things you buy to sell on", including stock and raw materials.
Why the classification matters
Moving a cost between cost of sales and overheads does not change net profit, but it changes the gross margin, and gross margin is what lenders, buyers and boards look at first. Inconsistent classification year to year makes trends meaningless, and loading overheads into stock defers costs into the next period. A clear chart of accounts, a documented stock costing policy and a reliable year-end count prevent most of the problems.
Acumon helps businesses set up cost of sales properly in their ledgers and report gross margin they can rely on. Our management accounts service tracks margin month by month, and our statutory accounts team handles stock valuation and the year-end presentation.