If your small business sells any kind of product, whether as a manufacturer or a reseller, having a keen eye on the “cost of goods sold” (COGS) can make a big difference to both your taxable income and business profits.
This article will explain more about what COGS is and how it can help you operate a better business, while saving money on your taxes.
What is COGS?
The cost of goods sold is the actual cost of the product you sell. This differs from other costs such as buying inventory, because it factors in the variable costs that go into procuring the product and getting it ready for sale, for example, the cost of raw materials, labor, production costs, and so on.
How to Calculate COGS
Calculating the cost of goods sold can be a complex process for many small businesses but there are a number of ways to streamline it:
- Keep good records (it will help you and the IRS requires it to support any COGS tax deduction claims)
- Separate your business and personal expenses
- Retain a good CPA or take advantage of online accounting programs to get fingertip access to your business’ key metrics.
Now, whether you do it yourself or rely on a CPA, it’s important to understand how the calculation is made. The IRS provides tons of information on how to calculate that cost of goods sold. In a nutshell, depending on your business, here’s what you may need to prepare in advance:
- The value of your inventory on January 1.
- Cost of purchases, these could be as-ready items or raw materials.
- Labor costs (for workers, not your salary as business owner).
- Cost of materials and supplies used in the manufacturing or sales process.
- Shipping costs.
- Container costs.
- Manufacturing overheads.
- Ending inventory on December 31.
Expenses you should exclude in your calculation include sales and marketing expense, rent, and sales commission payments. For a definition or more specifics about what these costs include, refer to IRS guidance.
Once you have all the data you need, you can use a simple calculation to determine COGS:
Beginning Inventory + Any Purchases of Inventory – Ending Inventory Balance.
However, to claim the tax deduction, you’ll need to provide more detail. The IRS advises that COGS should be calculated as follows:
- Value of inventory at the beginning of the year
- Plus net purchases
- Plus cost of labor
- Plus materials and supplies
- Plus other costs
- Minus value of inventory at the end of the year
- Equals COGS
Handling Variable Inventory Costs
In the real world, the cost of inventory rarely stays the same from January 1 through December 31. For example, you might purchase 50 tennis racquets from a vendor at $50 each in January, but then paid $60 each for the same item at the beginning of the busy tennis season in May.
How would you know which inventory items were sold at the higher price and which cost should you factor into your COGS calculation?
The answer depends on the inventory valuation method that you choose, these include: the First-In, First-Out method (or FIFO, in which oldest units are assumed to have sold first) or the Last-In, First-Out method (aka LIFO, which assumes newest units are sold before older units), or the self-explanatory Average Cost method.
Choosing the method that will work best for your tax situation is best done in consultation with a CPA.
How to Claim the COGS Deduction on Your Tax Return
Because the cost of goods sold can be one your biggest expenses, claiming the deduction can significantly reduce your taxable income – if you do it right.
As mentioned above, make sure you have records to back-up each of these costs, including invoices, receipts, credit card records, etc. Next, make sure you are only claiming the cost of goods sold. You can’t deduct the costs of any goods that you haven’t sold yet.
To file your claim, use Schedule C (sole proprietors and single-member LLCs) or Form 1065 if you operate a partnership of multi-member LLC.
How COGS Can Help You Run a Better Business
In addition to providing a nice tax deduction, having a clear understanding of the cost of goods sold can also help inform a number of business decisions such as how to price your products profitably by taking into account factors other than the basic cost of time and materials.
Make a point of comparing your COGS to your product pricing on a regular basis. This will give you the insight you need to ensure that you’re maintaining the necessary profit margins. It can also alert you to red flags, for example, if your COGS is higher than your product price point or margins are precariously low, then you know it’s time to revisit your pricing. Look for ways to reduce your overheads; and/or come up with a sales and marketing plan for boosting sales of unprofitable lines.
About the Author:
Fundbox is a technology company disrupting the small business payments market. Fundbox is helping SMBs, freelancers and home offices grow by managing their cash flow better and by overcoming short term cash flow gaps.