Cost of sales sits between turnover and gross profit, so every cost you put there changes the gross margin you report. The test for including a cost is simple to state: would this cost disappear if you sold nothing? Goods for resale, materials, production labour and subcontracted work pass the test. Rent, the accountant’s fee and the office broadband do not; they are overheads and belong below gross profit.
What counts as direct depends on the business
| Business | Direct costs (cost of sales) | Overheads (below gross profit) |
|---|---|---|
| Online retailer | Goods bought for resale, inbound freight, import duty, packaging sent with orders | Website hosting, marketing, office rent |
| Joinery workshop | Timber and fixings, machinists’ wages, workshop power | Admin salaries, bookkeeping, sales vehicle |
| Building contractor | Materials, plant hire for specific jobs, subcontractors, site labour | Head office, estimating software, insurance |
| Marketing agency | Freelancers and media bought for client campaigns | Account managers’ salaries if not tracked to jobs, office costs |
The line is a judgement and different accountants draw it in slightly different places. What matters is that you draw it the same way every month, or gross margin moves for reasons that have nothing to do with trading. Our explainer on cost of goods sold covers the concept in more depth.
A practical set of accounts
- Purchases – goods for resale
- Materials (for businesses that make or build)
- Carriage inwards and import duty
- Direct labour (if production staff are paid through payroll and you want them in gross margin)
- Subcontractors
- Stock movement (the opening and closing stock adjustment)
Split purchases by VAT treatment only if you buy a meaningful amount of zero-rated or exempt goods; the VAT return needs totals, not a line per rate on the purchase side.
Carriage inwards belongs to the goods
Delivery charges on goods coming in are part of what it cost to get the goods ready to sell, so they go to cost of sales, and they form part of the cost when stock is valued at year end. Carriage outwards, the cost of delivering to your customers, is a distribution cost. Mixing the two up flatters or depresses gross margin depending on which way the error runs.
Subcontractors and the Construction Industry Scheme
A contractor in construction who pays subcontractors must verify each one with HMRC and deduct tax from the labour element of each payment at the rate HMRC confirms, unless the subcontractor holds gross payment status. The deduction is paid to HMRC with the PAYE bill.
Example: a subcontractor’s invoice is £2,000 labour and £500 materials. HMRC has verified the subcontractor for deduction at the standard rate of 20%, so £400 is withheld from the labour.
| Account | Debit | Credit |
|---|---|---|
| Subcontractors | £2,500 | |
| CIS deductions payable | £400 | |
| Trade creditors | £2,100 |
If the subcontractor is VAT registered and the work falls under the domestic reverse charge, the invoice will show no VAT and the contractor accounts for it on its own return instead. Our guides to the Construction Industry Scheme and the construction reverse charge cover the two schemes separately, because they have different tests.
Purchases are not the same as cost of sales
In a business that holds stock, purchases in a month are rarely the same as the cost of what was sold. If a shop buys £30,000 of goods but sells goods that cost it £24,000, cost of sales is £24,000 and the remaining £6,000 is still on the shelves as an asset. The stock adjustment makes that correction; without it, a month of heavy buying looks like a collapse in margin. How the adjustment is posted is explained under inventory accounts.
Reading the gross margin
Gross margin = (turnover − cost of sales) ÷ turnover. With turnover of £200,000 and cost of sales of £124,000, gross profit is £76,000 and the margin is 38%.
That figure only means something if:
- turnover and cost of sales cover the same goods and the same period
- stock has been adjusted at the end of the period
- direct costs are coded consistently from month to month
- supplier rebates and settlement discounts reduce cost of sales rather than sitting in other income
A margin that swings by several points between months, with no change in pricing or product mix, is usually a cut-off or coding problem. Look first at large purchase invoices posted in the wrong month and at goods received but not yet invoiced. Gross profit explains how the figure is used in management reporting.
Presentation in the statutory accounts
Under Format 1, cost of sales is a line of its own and gross profit is shown on the face of the profit and loss account. Format 2 instead lists raw materials and consumables, staff costs and other charges by nature, with no gross profit line. Small companies filing abridged accounts can combine turnover and cost of sales into a single gross profit figure. Your nominal ledger supports any of these as long as direct costs are kept apart from overheads.