How To Calculate Cost of Goods Sold

What is Cost of Goods Sold? 

Cost of goods sold is a calculation of all the costs involved in selling a product.  Calculating cost of goods sold for products you manufacture or sell can be complicated, depending on the number of products and the complexity of the manufacturing process. 

Cost of goods sold is a required calculation as part of your business tax return, if you sell products. It reduces your business income, and thus your business taxes, so it's important to get it right. 

Cost of Goods Sold and Inventory

The calculation of 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 asset, with a specific value.

The process of calculating 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 determine the value of their inventory.

Calculating Cost of Goods Sold - Step by Step

This "how to" takes you through the calculation of cost of goods sold, so you can see how it is done and what information you will need to provide your CPA.

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 prepare it for your tax preparer.

Information Needed for the COGS Calculation

Before you begin, you will need some information:

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 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. 

For more information on inventory valuation and cost of goods sold, see IRS Publication 538 "Accounting Periods and Methods."

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 light 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 is: 

  • Beginning Inventory Costs (at the beginning of the year)
  • Plus Additional Inventory Costs
  • Minus Ending Inventory (at the end of the year)
  • Equals Cost of Goods Sold

For example:
$14,000 cost of inventory at the beginning of the year
+ $8,000 of cost of inventory and other costs
- $10,000 ending inventory
= $12,000 cost of goods sold.

Steps in Calculating 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 and Indirect.

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 are the most difficult to determine. This is where a good CPA comes in. Your CPA must allocate 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 Beginning Inventory

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

Your beginning inventory this year must be exactly the same as your ending inventory last year. If it does not, you will need to submit an explanation 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 items you make, you will need the help of your CPA to determine the cost to add to inventory.

Step 5: Determine 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 accountant help you. 

Cost of Goods Sold on Business Tax Returns

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

For sole proprietors and single-member LLCs using Schedule C, cost of goods sold is calculated in Part III and included in the Income section (Part I). Here's what the calculation looks like:

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, 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 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 do not 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 and on this site are intended to be general and not tax or legal advice. Every situation is different and circumstances change. Please get help from your tax preparer or tax advisor to make sure your calculations are correct.

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

Article Sources

  1. IRS. "Publication 538 Accounting Periods and Methods," Identifying Cost, Page 14. Accessed Nov. 7, 2019.

  2. IRS. Publication 334 Tax Guide for Small Business. "How to Figure Cost of Goods Sold," Pages 27-28. Accessed Nov. 6, 2019.

  3. Legal Information Institute. "26 CFR § 1.471-2 - Valuation of inventories." Accessed Nov. 7, 2019.

  4. IRS. Schedule C Profit or Loss from Business. "Part III Cost of Goods Sold." Accessed Nov. 6, 2019.

  5. IRS. Instructions for Schedule C. "Part III. Cost of Goods Sold," Page 14. Accessed Nov. 6, 2019.