I’ve had a number of small business owners ask me how to calculate cost of goods sold on their tax return. What I generally tell them is that reporting cost of goods sold is not required for most businesses. Read on for information on what cost of goods sold is and when it should be reported on your tax return.
What Is Cost of Goods Sold?
Cost of goods sold, or COGS, is defined as, “The direct costs attributable to the production of the goods sold by a company.” It is generally associated with manufacturing businesses and includes the cost of materials and labor directly used to create the goods or products. However, in the case of a retail business, COGS is the cost of the materials purchased for resale including any additional costs incurred to obtain the merchandise and get it ready for sale; such as shipping and handling costs. These costs are capitalized in an inventory account and expensed as product is sold.
But not only manufacturers and retailers use COGS in their accounting systems. For a construction industry business, such as a plumber or painter, that doesn’t manufacture a product for sale but does use materials and labor in the course of doing business, COGS are the costs of materials and supplies that are purchased to be directly incorporated into the jobs that are done as well as the labor hours expended by employees who work on those jobs.
In a personal service business, cost of goods sold changes to cost of services (COS) and is generally recognized as the labor costs, including payrolls taxes and benefits, of the people who generate billable hours.
Any business can use COGS or COS in their accounting system to differentiate costs associated with generating income from those associated with simply operating the business (aka overhead). But not all businesses are required to report COGS on their tax returns.
Does My Business Need to Report COGS On Its Tax Return?
While your small business may want to categorize costs as COGS in your accounting records, the IRS associates COGS only with those businesses that are manufacturers, wholesalers, or retailers or, any other business that makes, buys, or sells goods to produce income. So reporting COGS on the business tax return is really only necessary if your business’ main purpose is to make or buy goods to sell in order to produce income.
Reporting COGS does not apply to service businesses such as doctors, lawyers, carpenters, or painters. However, if you operate a service business and also sell individual products or materials, then reporting COGS would also apply to you. An example of this would be a lawyer who sells books, or an accountant who sells accounting software, or a painter who sells paint by the gallon in a retail environment.
In that case, you would need to maintain records of all inventory purchased for sale and do a physical inventory at the end of every year in order to calculate your cost of goods sold.
How Do I Calculate COGS?
There are a number of ways to calculate COGS but the most common way is to begin with the cost or value of beginning inventory, add the total cost of materials purchased for resale or if your company is an manufacturer, the costs of materials and labor purchased to make the product, then subtract the cost or value of the ending inventory. This calculation gives you the total cost of inventory that was sold by the company.
| ITEM | DESCRIPTION |
| Beginning Inventory | Cost of raw materials for manufacture or merchandise for sale on hand at beginning of the year |
| + Purchases for the year | Raw materials for manufacturing or merchandise for sale |
| + Cost of labor | Wages paid to employees for manufacturing; not included for retail |
| + Materials, supplies, other costs | Miscellaneous items directly used in the manufacturing process (e.g. hardware or chemicals, packaging, overhead) |
| – Ending Inventory | Value of inventory on hand at the end of the year |
| = COGS |
If your business performs a physical inventory at the end of the year and finds that there are fewer items or units on hand than is expected, this difference is referred to as inventory shrinkage and may be the result of damage, spoilage, theft, or poor record keeping. The cost of these missing items should be calculated and added to COGS as shrinkage.
Conclusion
If your small business is not a manufacturer, wholesaler or retailer, you can skip the section on Schedule C, or Forms 1065 and 1120 for reporting COGS. Instead, your costs associated with doing business (even if you classify them as COGS on your chart of accounts) will be expensed elsewhere on your tax return; Perhaps as “Materials used in construction,” “Parts and supplies,” or just, “Office expenses.”
I would welcome any questions you may have regarding COGS for your business.