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How To Calculate Cost of Goods Sold


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Calculating Cost of Goods Sold

Knowing the cost of the goods you sell allows you to take a larger tax deduction, so it is important to keep track of all costs related to your inventory of products. 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. 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 will need a CPA or tax professional to calculate COGS for your business income tax return


Difficulty: N/A

Time Required: Time Depends on the Variety of Products and Whether You Re-sell or Manufacture

Here's How:

  1. First, here are the basic components of the Cost of Goods Sold (COGS) calculation:
    Beginning Inventory Cost

    • Plus Cost of Additional Inventory Manufactured or Purchased during the year
    • Minus Cost of Ending Inventory
    • Equals Cost of Goods Sold

    For example:
    $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.

  2. 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.

  3. Determine Direct Costs, including
    Cost to purchase the merchandise for resale
    Cost of raw materials
    Packaging costs
    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)

  4. Determine Indirect Costs, including
    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)

  5. 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).

  6. 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.

  7. Add Purchases
    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.

  8. 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.

  9. LIFO or FIFO
    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.


  1. 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.
  2. If your business has less than $1 million in sales/receipts annually, you do not need to report inventory.
  3. For more information on inventory valuation and cost of goods sold, see IRS Publication 538 "Accounting Periods and Methods."
  4. 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.
  5. Disclaimer: The information in this article and on this site are intended to be general and not tax or legal advice. The Guide is not a CPA or attorney. Every situation is different and circumstances change. Please get help from your tax preparer or tax advisor to make sure your calculations are correct.

What You Need:

  • Value of inventory as of January 1 (same as end inventory December 31)
  • Cost of purchases - either items or raw materials/parts
  • Cost of labor
  • Cost of materials and supplies used in manufacture or sale
  • Shipping costs
  • Costs of containers
  • Overhead costs directly related to manufacture

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