Cost of sales is the cost of the goods or services actually sold in the period. For a trader that is the purchase cost of goods sold, adjusted for opening and closing stock; for a manufacturer it adds direct labour and production overheads; for a service business it is the cost of the people and inputs that deliver the work. Selling, delivery and general office costs are overheads below gross profit. Moving a cost across that line changes gross margin but not the bottom line, which is why the split has to be consistent.

Where does cost of sales appear in UK accounts?

Format 1 of the profit and loss account in Schedule 1 to the Large and Medium sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410) starts with turnover, then cost of sales, then gross profit or loss, followed by distribution costs and administrative expenses. Note 14 to the formats says cost of sales, distribution costs and administrative expenses must each be stated after taking into account any necessary provisions for depreciation or diminution in value of assets. So depreciation of a factory machine belongs in cost of sales, and depreciation of a delivery van in distribution costs.

Format 2 has no cost of sales line. It analyses costs by nature instead: change in stocks of finished goods and work in progress, own work capitalised, raw materials and consumables, other external expenses, staff costs and depreciation. A business using Format 2 does not report a gross profit at all. Our page on profit and loss formats compares the two.

Which costs belong in cost of sales?

The starting point is the cost of the stock that has been sold. FRS 102 paragraph 13.20 says that when inventories are sold, their carrying amount is recognised as an expense in the period the related revenue is recognised, so whatever was capitalised as stock under Section 13 becomes cost of sales on sale. That includes:

  • Costs of purchase (paragraph 13.6): the purchase price, import duties and other taxes that are not recoverable, and transport, handling and other costs directly attributable to acquiring the goods. Trade discounts and rebates are deducted. Recoverable VAT is therefore excluded.
  • Costs of conversion (paragraph 13.8): 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 (paragraph 13.11), only so far as they bring the stock to its present location and condition.

Two further items normally sit in cost of sales because they arise from the production or holding of stock. Paragraph 13.9 says fixed overheads not absorbed because production was low or plant was idle are expensed in the period they are incurred. Paragraph 13.19 requires stock that is damaged, obsolete or worth less than cost to be written down to selling price less costs to complete and sell, with an impairment loss recognised. Our page on stock valuation covers that test.

Which costs are overheads instead?

FRS 102 paragraph 13.13 lists costs that must be excluded from the cost of stock and expensed as incurred:

  • abnormal amounts of wasted materials, labour or other production costs;
  • storage costs, unless necessary in the production process before a further production stage;
  • administrative overheads that do not contribute to bringing stock to its present location and condition; and
  • selling costs.

In a Format 1 profit and loss account, selling and outward delivery costs usually go to distribution costs, and office, finance and management costs to administrative expenses. Abnormal waste is a judgement call: it is a production cost, so many businesses keep it in cost of sales but disclose it if material. The point of paragraph 13.13 is that it is not carried forward in stock.

What goes in cost of sales for a service business?

Service businesses rarely hold goods, but they do have direct costs. FRS 102 paragraph 13.14 says that where a service provider has inventories, their cost consists primarily of the labour and other costs of personnel directly engaged in providing the service, including supervisory personnel, and attributable overheads. Labour and other costs of sales and general administrative staff are excluded, as are profit margins and non attributable overheads.

A consultancy following that logic would put fee earners’ salaries, subcontractors and project expenses in cost of sales, and partners’ marketing time, reception and premises in overheads. Our page on work in progress for service businesses explains how unbilled time is valued at the year end.

How does the split change gross margin?

Illustration only. A small manufacturer has sales of £500,000, materials of £200,000, production wages of £100,000, delivery costs of £30,000 and office costs of £70,000, with no change in stock.

Production wages in cost of sales Production wages in overheads
Sales 500,000 500,000
Cost of sales (300,000) (200,000)
Gross profit 200,000 300,000
Gross margin 40% 60%
Distribution and administrative costs (100,000) (200,000)
Operating profit 100,000 100,000

The second column is wrong under Section 13, because direct labour is a cost of conversion, and it flatters the margin by twenty percentage points. Operating profit is the same either way. That is why gross margin comparisons between businesses, or between years after a change of bookkeeper, need care. The profit measures page explains what each level tells owners and lenders.

How does cost of sales appear on a sole trader’s tax return?

HMRC’s notes to the full self employment pages (SA103F) 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. Anyone using traditional accounting must adjust for opening and closing stock. Taxi and minicab drivers and road hauliers put fuel in box 17 rather than with other motoring costs. Payments to construction subcontractors go separately in box 18.

The notes also say the cost of goods bought for private use, and depreciation of equipment, are disallowable; if included in box 17 they must be added back in the disallowable column. Where the owner takes stock for personal use, see goods taken for own use.

Why does HMRC look closely at cost of sales?

Because gross profit rate is HMRC’s most used test of whether takings have been fully declared. The Enquiry Manual at EM3082 calls it the most commonly used business ratio in HMRC and defines it as gross profit (sales less cost of goods sold) divided by turnover, multiplied by 100. EM3090 adds that for a manufacturer it may be proper to take production wages into account as well as raw materials.

An unexplained drop in margin, or a margin well below what the trade would expect, is a common reason for questions. EM3509 notes that wastage reduces gross profit from the theoretical maximum and that officers should discuss it with the proprietor in precise terms. Good records of waste, breakages and price reductions are the best answer to a margin challenge.

What mistakes come up most often?

  • Capital items coded to purchases. Equipment bought for the business is a fixed asset, not a cost of goods sold.
  • Including recoverable VAT in the cost of goods, contrary to paragraph 13.6.
  • Forgetting the stock adjustment, so cost of sales equals purchases and margins swing with buying patterns rather than trading.
  • Inconsistent classification from year to year, which makes margin trends meaningless.
  • Putting outward carriage in cost of sales for one product line and in distribution for another.

For how purchases flow into cost of sales during the year, see perpetual and periodic stock systems.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.