Understanding Cost of Goods Sold (COGS)

What You Need to Know About COGS, From Calculations to Taxes

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Businesses must track all of the costs that are directly and indirectly involved in producing and distributing their products for sale. These costs are called 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.

COGS 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. Including all of your costs in the COGS calculation 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 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.

The COGS examples in this article use Schedule C for Form 1040/1040-SR. Income tax forms for other business types use the same general formula.

COGS is calculated 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

Inventory is the most important part of COGS. It includes:

  • Merchandise or stock in trade
  • Raw materials
  • Work in process
  • Finished products
  • Supplies that physically become a part of the item

Also, don't forget product containers and goods on display at a store or booth.

Direct Costs

COGS includes both direct and indirect costs. The direct costs include costs for making the product or the wholesale price of goods. These include:

  • 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:

  • Interest
  • Rent
  • Taxes
  • Storage
  • Purchasing
  • Processing
  • Repackaging
  • Handling
  • Administrative costs
  • Other overhead costs for running your warehouse or production facility, like light, heat, insurance, and maintenance

Information Needed to Calculate Cost of Goods Sold

In order for you or your tax preparer to calculate COGS, 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: This is 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: This includes indirect labor, shipping containers, freight on materials and supplies, and 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 get an accurate count.

Calculating Cost of Goods Sold

COGS 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, which should be the same as the ending inventory from 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:

Cost of Goods Sold Calculation

Valuing Inventory for Cost of Goods Sold

Report inventory at the cost to make or buy it, not the cost to sell it. If your business sells items that change costs during the year, you must figure out how to deal with those changes in a manner acceptable to the Internal Revenue Service (IRS).

For example, 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. The agency allows small businesses (with annual gross receipts of $25 million or less) to not keep an inventory if they use a way of accounting for inventory that "clearly reflects income."

Methods of Valuing Inventory

Inventory can be valued in one of three ways:

  • FIFO ("First-In, First-Out") assumes that the first goods bought are the first goods sold. S
  • LIFO ("Last-In, First-Out") assumes that the first goods bought are the first goods sold.
  • Specific identification for items that have unique costs (like an inventory of cars)

How to Include COGS in Business Taxes

COGS 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:

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

Frequently Asked Questions

Is the calculation for cost of goods sold included on tax preparation software?

Most business tax preparation software programs include the COGS calculation, depending on the version you are using. If you are filing your business tax return on Schedule C, make sure this schedule is included in the version for your personal tax return.

Where does cost of goods sold fit in the calculation for taxable income?

Here's a simplified process for getting net income: Start with gross receipts or sales. Then subtract cost of goods sold to get gross profit. Then subtract all other business expenses to get net income, which is the amount used to calculate business income taxes and self-employment tax.

How do I know which inventory valuation method to use?

Most businesses use either LIFO or FIFO, depending on their tax situation. FIFO is the default, and businesses may elect FIFO if they are eligible. This is a good question for your tax professional because the tax rules are complicated.