How to Include Cost of Goods Sold on a Business Tax Return
COGS Schedule C, Partnership Returns, and Corporate Tax Forms
Cost of goods sold (COGS) is a calculation of the value of a company's inventory, both that which has already been sold and that which remains to be sold. Cost of goods sold also includes all of your costs for making products, storing them, and shipping them to customers. To calculate the cost of goods sold you must value your inventory at the beginning and end of the year.
COGS is an important part of your business tax return if you make products to sell or you buy products and resell them. This calculation captures production costs that wouldn't be included in any other way, and these costs reduce your business taxable income.
What's Included in COGS?
Cost of goods sold includes direct costs related to the products you are selling:
- Cost of products for sale or raw materials, including freight
- Storage of products, raw materials, or parts used in production.
- Direct labor costs (including contributions to pensions or annuity plans) for workers who produce the products
- Factory overhead and warehouse costs.
Cost of goods sold doesn't include indirect costs, including:
- General overhead costs for areas of your business not related to the production or storage of products.
- Cost of managers and administrative employees.
Keep in mind that you can't also use a cost of goods sold expense as a business expense tax deduction in the "Expenses" section of your business tax return if you include this expense in the calculation of the cost of goods sold.
The first – and last – steps in calculating the cost of goods sold is taking inventory. You will need to know the value of that inventory, including:
- Merchandise or stock
- Raw materials
- Work in process
- Finished products, and
- Supplies that are part of inventory items.
Your cost of goods sold total is only as good as your inventory. Make sure you include all costs in your inventory calculations and get an accurate count. If you have a large, complex inventory you may want to use inventory control software to keep track and make inventory easier.
Calculating Cost of Goods Sold
The cost of goods sold is calculated in a separate section of your business tax return, not in the list of expenses. It's deducted from your company's gross receipts to figure a gross profit for the year.
The process for calculating the cost of goods sold is the same for all business types. Before you begin, you will need to set the inventory valuation method you want to use – cost, lower of cost or market, or retail. The cost of inventory can be specific identification, LIFO, or FIFO.
Gather Information. Begin by gathering the necessary information about your inventory:
- Start with the inventory of products you had at the beginning of the year.
- Then calculate the costs of all products, parts, or raw materials purchased during the year.
- Include the cost of labor, materials, and supplies directly related to making, storing, or shipping the products you sell.
- Include other costs, like shipping, freight, and overhead (rent, electricity, etc., for the production areas and warehouse.
Calculate COGS. Now you'll do the cost of goods sold calculation. It starts with the beginning inventory (inventory at the beginning of the year) and adds in the costs of materials and labor sold during the year It then calculates your ending inventory (at the end of the year).
The Formula for Cost of Goods Sold
- Beginning Inventory Costs (at the beginning of the year)
- Plus Additional Inventory Cost (inventory purchased during the year and other costs)
- Minus Ending Inventory (at the end of the year)
- Equals Cost of Goods Sold
Cost of Goods Sold for Small Businesses
The general IRS rule is that businesses with inventory must use actual accounting rather than cash accounting. This method is more complex, so the IRS has recently made inventory easier for small businesses.
If you have a small business, you don't have to keep an inventory or capitalize (depreciate) certain costs, rather than deducting them. To avoid capitalizing, you must comply with IRS requirements for accounting for that inventory. You can account for inventory as non-incidental materials and supplies or use a method that conforms to your financial accounting treatment for inventories.
To use this easier method of valuing inventory, you must:
- Use the accrual method of accounting, and
- You must value the inventory every year to determine COGS.
To qualify as a small business, you must have $25 million or less in average annual gross receipts (indexed for inflation), for the past three tax years, and your business can't be a tax shelter (as defined by the IRS).
This small business provision is complex. Check with your tax professional to get more information on how to value inventory.
COGS Calculation on Your Business Tax Return
The Internal Revenue Service provides worksheets for calculating COGS. The one you would use depends on the type of tax return you're filing. For sole proprietors and single-owner LLCs, the calculation is done on Schedule C. For all other business types, the calculation is done on Form 1125-A.
Sole Proprietor or Single-owner LLC
Sole proprietors and single-owner LLCs calculate and report their business taxes on Schedule C. The cost of goods sold calculation is in Part III. This calculation is added to other expenses and income to get a net income (taxable income) for the business. This amount is included with other business income on Line 12 of Schedule 1 of your 1040. Then the total from Schedule 1 is moved to your 1040 form.
Other Business Types Using Form 1125-A
IRS Form 1125-A is used to calculate the cost of goods sold for corporations, S corporations, partnerships, and multiple-member LLCs.
The form asks for:
- Inventory at the beginning of the year,
- The total of purchases, cost of labor, and other costs,
- Inventory at the end of the year.
- The calculation for COGS (as described above).
You will need to report the method you used to value inventory.
Here are the details for each business type:
Corporations. Form 1120 is the U.S. corporate income tax return. Form 1120 is used to calculate the net income, profit or loss, of all incorporated businesses. The cost of goods sold is calculated on Form 1125-A and included on Line 2 of Form 1120.
Partnerships and Multiple-owner LLCs. Form 1065, the U.S. Return of Partnership Income, is used to calculate the net income, profit or loss, of partnerships. The cost of goods sold is calculated on Form 1125-A and included on Line 2 of Form 1065.
S Corporations. An S corporation files its business income taxes on Form 1120S. The cost of goods sold is calculated on Form 1125-A and included on Line 2 of Form 1120S.
Do I Need an Accountant for Cost of Goods Sold?
The information in this article is a general overview and it's not intended to be tax preparation advice.
If you have a very simple business and the COGS calculation is fairly straightforward, you might be able to do this yourself. The most difficult part is typically the inventory valuation method—LIFO, FIFO, actual, or average—which can be quite complicated. It's always worthwhile to have a tax preparer do at least this part of the calculation and perhaps even to review everything when you've finished.