Understanding Cost of Goods Sold (Cost of Sales)

Cost of Goods Sold Explained
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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.

COGS and other business costs must be calculated so that your business can offset them against the revenue it generates and reports on its tax return. Claiming all of the company's expenses ensures that you will only pay taxes on the net income from the business, or the income that's left after all expenses have been covered.

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

What Is Cost of Goods Sold (COGS)?

COGS is sometimes referred to as 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 on 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. Specifically, it can include:

  • Cost of raw materials.
  • Cost of items purchased for resale.
  • Cost of parts used to construct a product.

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.

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

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.

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.

LIFO, FIFO, and Average Cost

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.
  • Average cost looks at all shirts bought and figures average cost per shirt, which is $5.12. Multiply by 500 shirts sold for a total cost of $2,580.

    When selecting a cost method, you'll need to make your choice based on certain guidelines provided by the IRS. Once you choose a certain method, the IRS has regulations governing these methods, so check with your tax advisor before calculating cost of goods sold. You can read more here on FIFO and LIFO accounting and how each choice can affect your business profits.

    How COGS Is Included in Business Taxes

    Cost of goods sold is an expense of doing business, and the COGS calculation is included in the business tax form for every business type where applicable. Thus, it will be a consideration for sole proprietors, partnerships, and C corporations.

    Keep Records on Inventory Costs

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