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What is Cost of Goods Sold?

Small-business owners should be familiar with the term cost of goods sold, as it ultimately impacts their profit and tax liability. Read this article to learn what cost of goods sold is, how it's calculated, and the importance of calculating it correctly.
A business person doing inventory at her coffee shop

Businesses that sell goods, whether they manufacture them or buy and resell them, must figure the cost of goods sold (COGS). COGS is a reduction to gross receipts, which is the amount received from sales, whether retail or wholesale. The reduction — which reflects what's held in inventory — is necessary to determine the actual amount of gross revenue from sales. Accounting and tax rules have created this adjustment instead of having businesses separately deduct the costs that go into COGS.

Defining cost of goods sold (COGS)

COGS represents the direct costs involved in producing goods or buying products for resale. Direct costs for goods purchased for resale include the purchase price of items, freight, storage, packaging, and direct labor costs. For manufactured goods, direct costs also include raw materials (including freight), storage, direct labor costs, and production expenses (factory overhead).

COGS doesn't include expenses for the company's managers and administrative personnel. It also doesn't include overhead costs not related to the storage of items or the manufacturing process.

Costs taken into account in COGS cannot also be separately deducted. For example, if you include freight in COGS, which you should, you can't separately deduct freight costs.

Small businesses — those that meet a gross receipts test — are not required to keep inventory. Instead, they can account for the cost of inventory items as non-incidental materials and supplies. A small business in 2019 and 2020 is one with average annual gross receipts in the three prior years not exceeding $26 million. The following discussion assumes that the business does not meet the gross receipts test and must account for inventory (i.e., figure COGS).

What do you need to calculate COGS?

To be able to figure cost of goods sold, you need certain key information:

  • Inventory at the start of the year: Businesses typically perform a physical inventory at the end of the previous year, which is then used as opening inventory for the current year.
  • Direct costs: These are costs of purchasing items for resale or manufacturing items for sale (described earlier).
  • Inventory valuation method: The options for valuing closing inventory are cost, lower of cost or market, or some other acceptable valuation method (discussed later).
  • Method of inventory flow: This can be first-in first-out (FIFO), last-in first-out (LIFO), or other acceptable method. These options, and limitations on them, are also explained later.

What is the COGS formula?

COGS is an important factor in accounting for the real revenue derived from the sale of goods. The simple formula for determining the cost of goods sold for the year for a business that buys items for resale is as follows:

Inventory at the beginning of the year

+ Inventory items purchased during the year, plus other applicable costs

- Inventory at the end of the year

= Cost of Goods Sold (COGS)

Cost of goods sold example

A company buys items for resale to its customers. It's beginning inventory is $10,000. During the year it buys $25,000 additional items for inventory. Inventory on hand at the end of the year is $12,000. As a result, the cost of goods sold is $23,000.

Why is COGS important?

Determining the amount of the COGS is vital for both financial and tax purposes.

Financial purposes: COGS is part of your income statement (also referred to as a profit and loss statement). It's an adjustment to your sales figures on the income statement. Knowing COGS can also help you reduce expenses or raise prices to maintain a targeted profit margin.

Tax purposes: On the business's tax return, COGS is reported as a reduction to gross receipts. It is figured on Form 1025-A for C corporations, S corporations, and partnerships, or in Part III of Schedule C for sole proprietorships.

When it comes to COGS, there is a tension between financial and tax reporting purposes. For financial reporting purposes, you want to maximize profits on your income statement. This demonstrates business growth and makes you better able to obtain business loans. For tax purposes, you typically want to minimize profits to save taxes. Thus, if you figure COGS in such a way as to produce higher profits, it's going to be more costly in terms of taxes.

Accounting methods and COGS

Your financial accounting treatment of inventories is determined with regard to the method of accounting you use to keep your books and records. Generally, inventory-based businesses, such as retailers, use the accrual method of accounting. However, some service-based businesses that also sell items (e.g., a hair salon that also sells shampoos and other products) may report on the cash method.

You must decide on a valuation method for inventory:

  • Cost: This is the cost based on using FIFO, LIFO, or average cost method (explained next). This is the most common method for valuing inventory. If you are on the cash method of accounting, you must use cost for valuing inventory.
  • Lower of cost or market: Inventory may be valued below cost when merchandise is unsalable at normal prices due to goods being damaged, shopworn, having imperfections, or being dated (out of fashion)/obsolete. The term "market" for normal goods means the current bid price prevailing on the inventory valuation date for the particular merchandise in the volume usually purchased by the business.
  • Other acceptable valuation method: One example is net realizable value, which values inventory at estimated selling price less the costs for disposing of them (a method that might be used, for example, when items can only be sold below cost).

FIFO

FIFO is shorthand for First In First Out to determine what's in inventory. FIFO assumes that the items purchased first are the first ones to be sold, regardless of which items are actually sold. For example, in January a business buys 10 items at $5 each. In May, it buys another 10 identical items at $6 dollars each and in September sells 12 items. Under FIFO, the first 10 items had a price of $5 each; the other two has a price of $6 each. These dollar amounts are factored into the ending inventory for the year.

The FIFO method can be used under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

Assuming inflation or rising prices (the natural course of events), the FIFO creates the lowest COGS, which in turn shows the greatest profit. It results in higher taxes than possible with other methods. Nonetheless, FIFO is usually the method of choice for most businesses. It's almost always used by businesses that sell perishable items or items that have a short shelf life (seasonal clothing or other items).

LIFO

LIFO stands for Last In First Out. It means that in determining ending inventory, the last items bought are treated as the first items sold. In the example above, 10 of the 12 items are priced at $6 each; only two are priced at $5 each.

The LIFO method can be used under Generally Accepted Accounting Principles (GAAP), but not for International Financial Reporting Standards (IFRS). IFRS is required for certain U.S. businesses (e.g., a U.S. company that's a subsidiary of a foreign company). Any business required to use IFRS must use FIFO; they cannot use LIFO. Increasingly, U.S. businesses permitted to use LIFO are converting to FIFO. (From time to time there have been proposals in Congress to repeal the use of LIFO.) U.S. businesses permitted to use LIFO and continue to do so must also use LIFO for any financial statements, but must also use footnotes in these reports to convert to FIFO.

Again, assuming inflation or rising prices (the natural course of events) and that the use of LIFO is permissible, it creates the highest COGS, which in turn minimizes profits and taxes. Thus, it continues to be used by many small businesses.

Average cost method

As the term implies, this is based on the total cost of items purchased for inventory. Essentially, it's a weighted average, factoring in the various prices paid for items. Continuing the example above, the average cost of the items is $5.50, which is used in determining ending value. The average cost of items is figured by computing total costs and then dividing it by the number of items sold.

Specific identification method

If a business sells expensive or unique items, the specific identification method (also referred to as the actual cost method) can be used to determine ending value. For example, if your business sells antiques, each item's actual cost (or lower of cost or market value if applicable) is taken into account because of the special cost associated with each item sold. Vehicle dealers may also prefer this method.

Using COGS as part of your inventory accounting

When you start your business, you can choose the inventory method most favorable to you (within the parameters outlined above). If you make a change, you must file for a change of accounting method (IRS Form 3115), which may require reporting additional income for tax purposes resulting from the change. If a C corporation using the LIFO method makes an S corporation election, there is an additional tax — LIFO recapture — one quarter of which is included in the C corporation's last year and three quarters of which are reported on the S corporation's first three returns (a quarter each year). Paychex can help with proper reporting of COGS for tax purposes. Paychex can also help you with inventory controls so you always know what you have on hand.

 

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