How To Calculate Cost of Goods Sold

If your business sells products, you need to know how to calculate the cost of goods sold. This calculation includes all the costs involved in selling products. Calculating the cost of goods sold (COGS) for products you manufacture or sell can be complicated, depending on the number of products and the complexity of the manufacturing process. 

The July 15 extension day for filing 2019 taxes has passed. If you applied for an extension to October 15, 2020, you must file your taxes by that date. If you must make quarterly estimated tax payments for 2020 taxes the remaining due dates of September 15, 2020, and January 15, 2021, are still in place.

Cost of Goods Sold and Inventory

The calculation of the cost of goods sold is focused on the value of your business's inventory. If you are selling a physical product, inventory is what you sell. Your business inventory might be items you have purchased from a wholesaler or that you have made yourself and are reselling. You might also keep an inventory of parts or materials for products that you make. Inventory is an important business asset, with a specific value.

The process of calculating the cost of goods sold starts with inventory at the beginning of the year and ends with inventory at the end of the year. Many businesses have a process of taking inventory at these times to figure the value of their inventory.

This "how-to" takes you through the calculation of the cost of goods sold, so you can see how it is done and the information you will need to give to your tax professional.

You most likely will need a tax professional to calculate COGS for your business income tax return. But you should know the information needed for this calculation, so you can collect all the information to include in this report.

Information for the COGS Calculation

Before you begin, you will need some information:

Accounting method. The IRS requires businesses with inventory must account for it by using the accrual accounting method.

If you are a small business with annual gross receipts of $25 million or less for the past three years, you may be able to choose not to keep an inventory and not use the accrual method for accounting. Check with your tax professional before you make any decisions about cash vs. accrual accounting. 

Inventory cost method. You will need will value the cost of your inventory. The IRS allows several different methods (FIFO or LIFO, for example), depending on the type of inventory. The IRS has detailed rules for which identification method you can use and when you can make changes to your inventory cost method.

You will also need to gather other information about your inventory:

  • Beginning inventory, the value of all the products, parts, and materials in your inventory at the beginning of the year. It must be the same as your ending inventory at the end of the year before.
  • Cost of purchases for inventory.
  • Cost of labor, to make products and ship them. It's basically the people who work directly with the products.
  • Cost of materials and supplies used to make and ship products.
  • Other costs, including shipping containers, freight costs, and warehouse expenses like rent, electricity, etc.
  • Ending inventory - the value of all items in inventory at the end of the year.

The Basic Cost of Goods Formula

The basic formula for cost of goods sold is: 

  • Beginning Inventory (at the beginning of the year)
  • Plus Purchases and Other Costs
  • Minus Ending Inventory (at the end of the year)
  • Equals Cost of Goods Sold.

An Example of the Cost of Goods Sold Calculation


$14,000 cost of inventory at the beginning of the year
+ $8,000 for purchases of materials or products, and other costs
- $10,000 ending inventory
= $12,000 cost of goods sold.

Steps in Calculating the Cost of Goods Sold

Step 1: Determine Direct and Indirect Costs

The COGS calculation process allows you to deduct all the costs of the products you sell, whether you manufacture them or buy and re-sell them. List all costs, including cost of labor, cost of materials and supplies, and other costs.

There are two types of costs included in COGS:

  • Direct Costs are costs related to the production or purchase of the product.
  • Indirect Costs are costs related to warehousing, facilities, equipment, and labor.

Here's an example of the difference between direct and indirect costs:

Direct labor cost is wages you pay to employees who spend all their time working directly on the products your company makes, including both full-time and part-time employees.

Indirect labor cost is wages you pay to employees who work in your factory who don't have any immediate or direct connection with making the product. These might include stocking, packaging, and shipping workers.

Step 2: Determine Facilities Costs

Facilities costs (for buildings and other locations) are the most difficult to determine. This is where a good tax professional comes in. You must set a percentage of your facility costs (rent or mortgage interest, utilities, and other costs) to each product, for the accounting period in question (usually a year, for tax purposes).

Step 3: Determine the Beginning Inventory

Inventory includes the merchandise in stock, raw materials, work in progress, finished products, and supplies that are part of the items you sell.

Your beginning inventory this year must be exactly the same as your ending inventory last year. If the two amounts don't match, you will need to submit an explanation on your tax form for the difference.

Step 4: Add Purchases of Inventory Items

Most businesses add inventory during the year. You must keep track of the cost of each shipment or the total manufacturing cost of each product you add to inventory. For purchased products, keep the invoices and any other paperwork. For the items you make, you will need the help of your tax professional to determine the cost to add to inventory.

Step 5: Determine the Ending Inventory

Ending inventory costs are usually determined by taking a physical inventory of products, or by estimating.

Ending inventory costs can be reduced for damaged, worthless, or obsolete inventory. For damaged inventory, report the estimated value. For worthless inventory, you must provide evidence that it was destroyed. For obsolete (out of date) inventory, you must also show evidence of the decrease in value.

Step 6: Do the COGS Calculation

At this point, you have all the information you need to do the COGS calculation. You can do it on a spreadsheet, or have your tax professional help you.

Cost of Goods Sold on Business Tax Returns

The process and form for calculating the cost of goods sold and including it on your business tax return are different for different types of businesses. 

For sole proprietors and single-member LLCs using Schedule C as part of their personal tax return, the cost of goods sold is calculated in Part III and included in the Income section (Part I) of this schedule.

Here's what the calculation looks like on Schedule C for small business taxes:

Cost of Goods Sold on Schedule C
Inventory at Beginning of Year     $15,500
Plus Purchases         8,331
Plus Cost of Labor       12,350
Plus Materials and Supplies         8,200
Plus Other Costs         1,100
   Sub-total     $45,531
Minus Inventory at End of Year       18,330
Equals Cost of Goods      $27,201

For partnerships, multiple-member LLCs, corporations, and S corporations, the cost of goods sold is calculated on Form 1125-A. This form is complicated, and it's a good idea to get your tax professional to help you with it. 

Some Additional Tips for This Calculation

  1. You can only deduct the cost of goods sold if you have sales. If you purchase or make products to sell, and you don't sell any products, you can't deduct these costs.
  2. If your business has less than $1 million in sales/receipts annually, you don't need to report inventory, but you must still use an accounting method that clearly reflects income. If you decide to keep an inventory, you generally must use the accrual accounting method.

Disclaimer: The information in this article is for your general information; it's not tax or legal advice. Every business situation is different and tax regulations change. Please get help from your tax preparer to make sure your calculations are correct.

For more details and special circumstances on calculating the cost of goods sold, see this article from IRS publication 334 Tax Guide for Small Business

Article Sources

  1. IRS. "Publication 538 Accounting Methods and Periods." Page 13. Accessed Aug. 6, 2020.

  2. IRS. "Publication 538 Accounting Periods and Methods." Page 14. Accessed Aug.6, 2020.

  3. IRS. "Publication 334 Tax Guide for Small Business." Page 27. Accessed Aug. 6, 2020.

  4. Cornell Legal Information Institute. "26 CFR § 1.471-2 - Valuation of inventories." Accessed Aug. 6, 2020.

  5. IRS. "Schedule C Profit or Loss from Business." Accessed Aug. 6, 2020.

  6. IRS. Instructions for Schedule C. Page 14. Accessed Aug. 6, 2020.