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. It reduces your business income, and thus your business taxes, so it's important to get it right.
Calculating Cost of Goods Sold - Step by Step
This "how to" takes you through the calculation for one product, so you can see how it is done and what information you will need to provide your CPA. You most likely will need a CPA or tax professional to calculate COGS for your business income tax return.
Before you begin, review this article on the information you will need in order to calculate cost of goods sold. You will need to know the amounts of each component of the equation. Basically, you will need to know the beginning and inventory amounts, and you will need all costs of inventory purchased during the year. In addition, you'll need to know which inventory valuation method your accountant wants you to use.
Step One: The Basic Components of the COGS Calculation
The basic calculation is:
- Beginning Inventory Costs (at the beginning of the year)
- Plus Additional Inventory Cost (inventory purchased during the year)
- Minus Ending Inventory (at the end of the year)
- Equals Cost of Goods Sold
$14,000 cost of inventory at beginning of year
+ $8,000 cost of additional inventory purchased during year
- $10,000 ending inventory
= $12,000 cost of goods sold.
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.
There are two types of costs included in COGS: Direct and Indirect.
- Direct Costs are costs related to production or purchase of the product.
- Indirect Costs are costs related to warehousing, facilities, equipment, and labor.
Step Two: Determine Direct Costs
Determine direct costs, including:
Cost to purchase the merchandise for resale
Cost of raw materials
Work in process
Cost of inventory of finished products
Supplies for production
Direct overhead costs related to production (for example, utilities and rent for manufacturing facility)
Step Three: Determine Indirect Costs
Indirect costs include manufacturing materials and supplies
- Labor (for workers who actually touch the product)
- Costs to store/wholesale the products
- Depreciation of equipment used to produce, package, or store the product
- Salaries of administrators, managers overseeing production
- Equipment used for administrative work (not production)
Step Four: 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 Five: Determine Beginning Inventory
Inventory includes 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 Six: 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 Seven: 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 inventory, you must also show evidence of the decrease in value. Consider donating obsolete inventory to a charity.
Step Eight: 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.
Inventory Valuation Methods
The final item to be determined is how which inventory has been sold. There are two acceptable methods for determining which inventory is left at the end of the accounting period: LIFO (Last in, first out), or FIFO (first in, first out).
Your CPA will help you determine which method is best for your business tax situation. If you change your valuation method, you must apply to the IRS for approval. For example, if this is the first year your business is using the LIFO method, you must apply to the IRS to make this change. Use IRS Form 970 - Application to Use LIFO Inventory Method.
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 LLC's using Schedule C, cost of goods sold is calculated in Part III and included in the Income section (Part I).
For partnerships, multiple-member LLC's, 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
- REMEMBER: 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.
- If your business has less than $1 million in sales/receipts annually, you do not need to report inventory.
- For more information on inventory valuation and cost of goods sold, see IRS Publication 538 "Accounting Periods and Methods."
- You cannot use the "lower of cost or market" method if you are using LIFO inventory valuation. You must use the "Cost" method of valuing inventory (not "lower of cost or market") if you use the cash accounting method. It is best to use the accrual method if you have inventory.
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.
COGS in action: How to determine the COGS of a sewing business.