Caiaimage / Paul Bradbury / Getty Images 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.
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. 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 tradeRaw materialsWork in processFinished productsSupplies 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 costsDirect 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:
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:
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:
For sole proprietors and single-member LLC owners, on Schedule C For partnerships and multiple-member LLCs, the cost of goods sold is part of the partnership tax return (Form 1065). For corporations and S corporations, the cost of goods sold is included in the corporate tax return (Form 1120) or the S corporation tax return (Form 1120-S).
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.
