What Is Cost of Goods Sold?
The cost of goods sold is how much it costs the business to produce the items it sells. 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. 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.
Basic Cost of Goods Sold Formula
The basic formula for the cost of goods sold is to start with the inventory at the beginning of the year and add purchases and other costs. From that number, subtract the inventory at the end of the year. Written out, it looks like this: Beginning inventory + purchases and other costs - ending inventory = COGS
Example of the Cost of Goods Sold Formula
Here’s an example of how the cost of goods formula works. Say you have $14,000 in inventory at the beginning of the year. You added $8,000 in materials or products. Your inventory at the end of the year is $10,000. The formula would be $14,000 + $8,000 - $10,000 = $12,000. Your cost of goods sold is $12,000.
What You Need To Calculate COGS
Before you begin, you will need some information:
Accounting Method
The Internal Revenue Service (IRS) requires businesses with inventory to account for it by using the accrual accounting method. There is an exception to this rule for small businesses. If you are a small business with annual gross receipts of $26 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
To use the inventory cost method, you will need to find the value 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, which must be the same as your ending inventory at the end of the year before.Cost of purchases (parts, materials, finished products) for inventoryCost of labor (paying employees to make products and ship them)Cost of materials and supplies used to create and ship productsOther costs, including shipping containers, freight costs, and warehouse expenses such as rent, electricity, etc.Ending inventory, which is the value of all items in the inventory at the end of the year
Steps in Calculating the Cost of Goods Sold
Once you have gathered the relevant information, you can calculate 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 productIndirect 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 employeesIndirect labor cost is wages you pay to employees who work in your factory who don’t have any immediate or direct connection with making products, including 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. You may need to physically count everything in inventory or keep a running count during the year. 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 limited liability companies (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 an example of what the calculation would look like on Schedule C for small business taxes:
