calculate cost of goods soldThe calendar has advanced to a new year and you can almost hear the collective sigh from business owners everywhere. That’s right: it’s tax time. Financial records, receipts, and invoices are being gathered and sorted to find out just how much the government is owed this year. Online business owners are not exempt, so you are probably feeling much of the same as tax season approaches.

One of the most important tax concepts and calculations for retailers to understand is the “cost of goods sold.” This is really important because you have to determine the value of your inventory. This post will focus on what that is, how to calculate cost of goods sold, and how to determine the value of your inventory for tax purposes.


What is Cost of Goods Sold?

The calculation cost of goods sold (COGS) is required on business tax returns. It lowers your business income, therefore lowering your business taxes, so it’s in your best interest to get it right.

Calculating the cost of goods sold takes into account all costs that are involved in selling your product. The calculation itself can be complicated, especially if you sell or manufacture multiple products. We’ve outlined the various steps for you to follow below to calculate your COGs. Visual learners: skip ahead to view an infographic.

You may already have a solution, like our online inventory software, in place that provides you with cost of goods sold reporting. Still, it’s important for you to understand the concept and what is involved in the calculation.


How to Calculate Cost of Goods Sold

The following is a step-by-step process to calculate cost of goods sold for one product.


Step #1 – Basic Elements of the Cost of Goods Sold Calculation

The basic calculation is simple:

Beginning Inventory + Additional Inventory – Ending Inventory = COGS

Here’s an example:

$15,000 (cost of inventory at the beginning of the year)

+ $6,000 (additional inventory purchased throughout the year)

– $11,000 (inventory at year end)

= $10,000 (cost of goods sold)

This calculation allows you to deduct the costs of the products you sell, whether you re-sell or manufacture your items.

Cost of goods sold includes two types of costs – direct and indirect. Direct costs are the expenses related to the production or purchase of your products. Indirect costs are related to the storage, facilities, labor and equipment used to sell your products.


Step #2 – Define Direct Costs

Calculate your direct costs, which include:

  • Cost to purchase products for resale
  • Cost of raw materials for manufacturing
  • Packaging costs
  • Cost of supplies for production
  • Direct overhead expenses that are production-related
  • Cost of inventory of completed products


Step #3 – Define Indirect Costs

Calculate your indirect costs, which include:

  • Labor (if you employ workers or hired temporary help)
  • Storage costs
  • Wages of managers or administrators who oversee production
  • Administrative equipment (not used for production)
  • Depreciation of equipment used for storing, producing, or packaging your product


Step #4 – Calculate Facilities Costs

This step is usually best done by a CPA or tax professional, as facilities costs can be difficult to determine. In essence, a certain percentage of the costs of your facilities (rent, mortgage interest, utilities, etc.) is allocated to each product.


Step #5 – Determine Initial Inventory

This number is easy to find. It must be equal to the amount of ending inventory from last year. It includes merchandise in stock, products in progress, and completed products.


Step #6 – Add Inventory Purchases

This is the total amount of every shipment for the year or manufacturing costs of each product added to your inventory.


Step #7 – Determine Ending Inventory

Ending inventory costs is typically determined by a physical inventory of stock on hand. Damaged or obsolete inventory can reduce your ending inventory costs.


Step #8 – Calculate COGS

You now have all of the information you need to do the COGS calculation. You can do it yourself, but it’s always advisable to have your tax preparer help you.


Determining the Value of Your Inventory

The final thing to do is determining which valuation method you will use for your inventory. The IRS accepts three methods.

  1. Cost – the price you paid for the item plus shipping costs
  2. Lower of cost or market value – the lesser of the cost or the market value on a specific date each year
  3. Retail – the retail value of your product less a set mark-up percentage

The easiest to keep track of is the cost method, so most smaller businesses use that method.

If you have products with costs that are difficult to determine you can use one of two methods to keep track: First In, First Out (FIFO) method or Last In, First Out (LIFO) method. There are advantages to each, and your tax professional can help you decide which one will work best for you. You then must stick to that method, or apply to the IRS for approval to change it in the future.


Things to Remember

  • Cost of goods sold deductions only include the items that have been sold. If you have purchased or manufactured products but they have not sold, you cannot deduct their costs. Therefore, there is no tax benefit to having a large inventory.
  • Current tax regulations do not require businesses that have less than $1 million in sales to report inventory.
  • You can find more information on the valuation of your inventory at IRS Publication 538.
  • Disclaimer: This post includes information that is general and is not legal or tax advice. Please enlist the help of a CPA or tax professional to help you with your calculations.


calculate cost of goods sold infographic

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