Understanding Cost of Goods Sold (Cost of Sales)

What's Needed for Cost of Goods Sold, and How It Affects Your Taxes

Cost of Goods Sold Explained
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Businesses need to track all of the costs that are directly and indirectly involved in producing their products for sale. These costs are called the cost of goods sold (COGS), and this calculation 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.

The cost of goods sold is deducted from your gross receipts to figure the gross profit for your business each year. Gross receipts are the amounts your business received from sales during the year. Claiming all of your business expenses, including COGS, increases your tax deductions and decreases your business profit.

Understanding all the costs included in the COGS calculation 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 1040/1040-SR. Income tax forms for other business types use the same general formula.

What Is Cost of Goods Sold (COGS)?

COGS is sometimes referred to as the cost of sales; it refers to the costs a company has for making products from parts or raw materials or buying products and reselling them. These costs are an expense of the business because you sell these products to make money.

How Cost of Goods Sold Works

Your business assembles a widget from inventory parts and sells it for $15.

The inventory parts, direct labor for assembly, and other costs included in cost of goods sold total $10.

The gross profit per widget is $5. If you didn't include all possible costs your profit would higher, meaning higher taxes.

The cost of goods sold is determined each year 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.

What's Included in Cost of Goods Sold

Cost of goods sold includes both direct and indirect costs.

Direct Costs. The direct costs include costs for making the product or the wholesale price of goods. Direct costs include:

  • Cost of buying products for resale, parts, or raw materials
  • Freight costs
  • Storage costs
  • Shipping costs
  • Direct labor costs for paying workers (including contributions to pensions or annuity plans) who produce the products

Indirect Costs. COGS also includes other costs such as

  • Warehouse and other facility costs, including utilities
  • Production equipment
  • Indirect labor (management and supervisors)
  • Other overhead costs for running your warehouse or factory

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 include an explanation of the difference in your tax return.
  3. Cost of purchases: Next, get a total of all the products you bought during the year and that you placed in inventory to sell. Subtract any products you took out for personal use. If you are making products, you'll need to include the total cost of all raw materials and parts you bought during the year.
  4. Cost of labor: This is your cost for employees who work directly making products from raw materials and parts. It doesn't include payroll 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 indirect labor, shipping containers, freight on materials and supplies, and overhead expenses for rent, light, heat, etc. only 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.

To get the value of your inventory at the beginning and end of the year, you may need to do some kind of physical (or electronic) inventory. Check with your tax professional for help on the best way to take inventory to get an accurate count.

Calculating the Cost of Goods Sold

The cost of goods sold calculation is based on 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

Considering Inventory Cost Changes

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 resell 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.

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 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 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.

How COGS Is Included in Business Taxes

The cost of goods sold calculation is included in the business tax form for every business type that sells products. The basic calculation is the same for all business types, but the form is different, depending on the business type.

Corporations, S corporations, partnerships, and LLCs enter the cost of goods sold calculation on Form 1125-A. The calculation is entered on the business tax form as an expense.

Sole proprietorships and single-member LLCs enter the calculation on Schedule C and include net income from Schedule C with the other income on their personal tax return (Form 1040/1040-SR).

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

  • For sole proprietors and single-member LLC owners, in Schedule C, the cost of goods sold is included in Part 1: Income.
  • For partnerships and multiple-member LLCs, the 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, the cost of goods sold is included in the corporate tax return (Form 1120) or the S corporation tax return (Form 1120-S). The 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.

Disclaimer. The cost of goods sold calculation is complicated, with many qualifications and restrictions. It's not intended to be specific directions for your business situation. Get help from a tax professional in calculating and reporting the cost of goods sold.