Understanding Cost of Goods Sold (Cost of Sales)

What's Needed for COGS and Where it's Included in Your Business Taxes

Cost of Goods Sold Explained
••• LWA/Larry Williams/Getty Images

Businesses need to track all of the costs that are directly involved in producing their products for sale, in addition to other operational costs. These direct costs are called the cost of goods sold (COGS), and this figure appears in the company's profit and loss statement (P&L). It's also an important part of the information the company must report on its tax return.

Claiming all of your business expenses ensures that you will only pay taxes on the net income from the business (the income that's left after all expenses have been covered). The cost of goods sold is deducted from your gross receipts to figure the gross profit for your business each year. The IRS describes gross profit as the gross receipts minus returns and allowances and minus cost of goods sold.

Understanding what's covered under COGS on the income statement will help you make sure that you don't miss any tax deductions.

The cost of goods sold examples in this article use Schedule C for Form 1040. At the end of the article, you can see how cost of goods sold is calculated and recorded for other business tax returns.

What Is Cost of Goods Sold (COGS)?

COGS is sometimes referred to as the cost of sales and refers to the production costs for products manufactured and sold or purchased and re-sold by the company. These costs are an expense of the business, and they reduce the revenue the company makes from selling its products.

For example, say your business assembles a completed widget from various inventory parts and sells it online for $15. The parts of the widget and the direct labor required to assemble them cost $10.

The $10 cost is deducted from the widget's sale price to determine the gross profit it generates, and the taxes on that profit. The IRS allows you to include a variety of costs in this calculation. 

Cost of goods sold is determined annually by showing changes in the company's balance of "goods" or inventory, from the beginning to the end of the company's fiscal (financial) year, and it is included in the company's income statement. The income statement information is included in the business tax return and used to calculate adjusted gross income as well as net income for tax purposes.

What's Included in Cost of Goods Sold

Cost of goods sold includes the direct cost of producing the product or the wholesale price of goods resold and the direct labor costs to produce the product. The following are types of expenses that go into figuring the cost of goods sold.

  • The cost of products or raw materials, including freight
  • Storage
  • Direct labor costs (including contributions to pensions or annuity plans) for workers who produce the products
  • Factory overhead

COGS also includes other direct costs such as labor to produce the product, supplies used in manufacture or sale, shipping costs, costs of containers, freight in, and overhead costs directly related to the manufacture or production activity (like rent and utilities for the manufacturing facility).

Finally, COGS includes indirect costs such as distribution costs and sales force costs that are also directly related to the products the company sells.

How COGS Affects Business Income

Because cost of goods sold is a cost of doing business, it is a business expense. As COGS increases, it reduces the company's net income or profit. That may result in paying less tax because your business has less income, but it also means the business doesn't make as much money overall, so it pays to keep COGS efficiently managed to increase profits.

Information Needed to Calculate Cost of Goods Sold

In order for you or your tax preparer to calculate the cost of goods sold, you will need the following information:

  1. Valuation method: Designate whether inventory is valued at cost, lower of cost or market, or other. If you use the cash accounting method, you must value inventory at cost. Check with your tax preparer if you have changed your method of determining quantities, costs, or valuations. You must include an explanation of any changes.
  2. Beginning inventory: The total cost of all the products in your inventory at the beginning of the year. This should be the same as the inventory at the end of last year. If it's not the same, you must provide an explanation.
  3. Cost of purchases: Next, get a total of all the products you purchased during the year and that you placed in inventory to sell. Subtract any products you took out for personal use. If you are a manufacturer, you'll need to include the total cost of all raw materials and parts purchased during the year. Don't worry about whether they are assembled or not.
  4. Cost of labor: This is your business's cost for employees who work directly making a product from raw materials and parts. It doesn't include costs for administrators or employees in sales, marketing, finance, or other areas.
  5. Cost of materials and supplies: These costs must be directly related to making the product.
  6. Other costs, including shipping containers, freight in on materials and supplies, and overhead expenses for rent, light, heat, etc. for the area where the products are being manufactured or assembled.
  7. Ending inventory. Determine the total value of all items in inventory at the end of the year.

How to Calculate Cost of Goods Sold

Cost of goods sold is determined by the change in inventory. The calculation starts with the inventory of products for sale or raw materials to produce products, at the beginning of the year (the inventory at the end of the previous year).

The cost of additional products purchased or produced during the year is added, and then inventory at the end of the year is subtracted. The result of this calculation is the cost of the inventory made and then sold by the company during the year. The basic calculation is as follows:

Beginning inventory

+ Cost of purchases/materials for items sold during the year

- Ending inventory

= Cost of goods sold for the year

This article on How to Calculate Cost of Goods Sold gives you more details on the process.

Considering Inventory Cost Changes

First, note that inventory is reported at the cost to make or buy it, not the cost to sell it. If your business sells items whose cost changes during the year, you must figure out how to deal with those cost changes in a manner acceptable to the IRS.

Let's say you buy a product and re-sell it. If the cost goes up during the year, you have to figure this increase into your COGS equation. The IRS has several approved ways to account for changes in costs during the year without having to track each product price individually.

This example of a sewing business shows how to keep track of inventory.

You might also want to do a cost of goods sold budget to help you determine your net cost and see where you could save money on sales of products.

Valuing Inventory for Cost of Goods Sold

Let's say you purchased t-shirts for resale during the year, in three batches:

  • Batch 1: 100 shirts at $5 each = $500
  • Batch 2: 300 shirts at $5.20 each = $1,520
  • Batch 3: 200 shirts at $5.25 each = $1,050

Now let's say you sold 500 shirts during the year and look at costs of products sold under each of these methods:

  • FIFO stands for "first in-first out," and it costs goods on the assumption that the first goods bought are the first goods sold. So the first 500 shirts bought would be costed under FIFO at $2,545.
  • LIFO stands for "last in-first out," and it costs goods on the assumption that the first goods bought are the first goods sold. So the last 500 shirts bought would be costed under LIFO at $2,570.

The IRS also allows you to use the specific identification method when you can identify and match the actual cost to items in your inventory. 

IRS Publication 538 Accounting Periods and Methods has a detailed explanation of inventory valuation for cost of goods sold.

How COGS Is Included in Business Taxes

The COGS calculation is included in the business tax form for every business type where applicable.

Cost of goods sold is calculated on Form 1125-A and attached fo tax returns for corporations, S corporations, and partnership. The calculation is entered directly on Schedule C. The basic calculation is the same for all business types.

If you are preparing your business taxes yourself using tax software, you will find the cost of goods sold calculation in the following business tax returns:

  • For sole proprietors and single-member LLC owners, in Schedule C, cost of goods sold is included in Part 1: Income.
  • For partnerships and multiple-member LLCs, cost of goods sold is part of the partnership tax return (Form 1065). it's included in Section 1: Income as part of the calculation for gross profit.
  • For corporations and S corporations, cost of goods sold is included in the corporate tax return (Form 1120) or the S corporation tax return (Form 1120-S). Cost of goods sold is included in Part 1 Income as part of the calculation of gross profit.

Keep Records on Inventory Costs

Like all other business expenses, you must keep adequate records to prove that your cost of goods sold calculation is accurate.

Cost of goods sold is a complicated subject, and this article is a general overview, not specific directions for your business situation. Get help from a tax professional in calculating and reporting cost of goods sold.

Article Sources

  1. IRS Schedule C Profit or Loss from Business (Sole Proprietorship). "Part 1 Income." Accessed Oct. 17, 2019.

  2. IRS. Deducting Business Expenses. "Cost of Goods Sold." Accessed Oct. 16, 2019.

  3. IRS. Publication 538. "FIFO Method and LIFO Method." Pages 14-15. Accessed Oct. 17, 2019.

  4. IRS. Publication 538. "Specific Identification Method." Page 14. Accessed Oct. 17, 2019.