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Cost of Goods Sold and Business Income Taxes

COGS Formula, Inventory, and Your Business Taxes

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What is Cost of Goods Sold (COGS)?
Cost of goods sold, sometimes referred to as "cost of sales" or "COGS," refers to the cost of products manufactured and sold or purchased and re-sold by the company. These costs of sales are an expense of the business and they reduce the profit the company makes on selling the products.

Cost of goods sold is determined annually showing changes from the beginning to the end of the company's fiscal (financial) year, and it is included in the company's business tax return as an expense.

What's included in cost of goods sold?
Cost of goods sold includes the direct cost of producing the product or the wholesale price of goods resold and the direct labor costs to produce the product. Specifically, it can include:

  • Cost of raw materials
  • Cost of items purchased for resale
  • Cost of parts used to construct a product.

COGS also includes other direct costs such as labor to produce the product, supplies used in manufacture or sale, shipping costs, costs of containers, freight in, and overhead costs directly related to the manufacture or production activity (like rent and utilities for the manufacturing facility).

Finally, COGS includes indirect costs such as distribution costs and sales force costs.

How does cost of goods sold affect business income?
Because cost of goods sold is a cost of doing business, it is a business expense. So if COGS increases, the company's net income is less. That may be great for paying less tax, but it means the business doesn't make as much money, so sales costs should be kept down, to increase profits.

How is cost of goods sold calculated?
Cost of goods sold is determined by the change in inventory. The calculation starts with the inventory of products for sale at the beginning of the year (the inventory at the end of the previous year). Then cost of products purchased or produced during the year is added and inventory at the end of the year is subtracted. This calculation gives the cost of the inventory made and then sold by the company during the year. The basic calculation is:

  • Beginning inventory
  • Plus cost of purchases/materials for items sold during the year
  • Minus ending inventory
  • Equals cost of goods sold for the year.
Read more details on how to calculate cost of goods sold.

What if inventory cost changes during the year?
First, note that inventory is reported at the cost to make or buy it, not the cost to sell it. If your business sells items whose cost changes during the year, you must figure out how to deal with those cost changes in a manner acceptable to the IRS. Let's say you buy a product and re-sell 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.

LIFO, FIFO, and Average Cost
Let's say you purchased t-shirts for resale during the year, in three batches:

  • Batch 1: 100 shirts at $5 each = $500
  • Batch 2: 300 shirts at $5.20 each = $1,520
  • Batch 3: 200 shirts at $5.25 each = $1,050
And let's say you sold 500 shirts during the year. Let's look at costs of products sold under each of these methods.

FIFO stands for "first in-first out" and it costs goods on the assumption that the first goods bought are the first goods sold. So the first 500 shirts bought would be costed under FIFO at $2,545.

LIFO stands for "last in-first out" and it costs goods on the assumption that the first goods bought are the first goods sold. So the last 500 shirts bought would be costed under LIFO at $2,570.

Average cost looks at all shirts bought and figures average cost per shirt, which is $5.12. Multiply by 500 shirts sold for a total cost of $2,580.

Selecting a cost method
You can't just decide on your own each year which cost method to use. The IRS has regulations governing these methods, so check with your tax advisor before calculating cost of goods sold. Rosemary Peavler, Guide to Business Finance, explains FIFO and LIFO accounting and how they can affect your business profits.

How does COGS fit in business taxes? Where does it get included?
Cost of goods sold is an expense of doing business, and the COGS calculation is included in the business tax form for every business type. It is part of the calculations for Schedule C for sole proprietorships, and it is included in the tax forms for corporations (Form 1120), S corporations (Form 1120-S), and partnerships (Form 1065).

Read more about how to include cost of goods sold in your business tax return.

What records must I keep on cost of goods sold?
Like all other business expenses, you must keep adequate records to prove your cost of goods sold calculation is accurate.

Read more about keeping records on cost of goods sold.

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