When you run your own business, the importance of accurately preparing your taxes cannot be understated. Part of getting things right include identifying and claiming all deductions for which your business is eligible to reduce your taxable income. If your business makes or resells goods, the “Cost of Goods Sold” is a significant business tax deduction that you need to properly utilize.
The “Cost of Goods Sold” (COGS) are a category of deductible business expenses that account for the costs of products that a business manufactures or resells. Calculating this amount for purposes of your IRS Schedule C (Profit or Loss From Business) can be complex, which is why it is wise to consult with a tax attorney when preparing your return.
The first step is to report your inventory accounting method, such as cost, “lower of cost or market”, or any accounting method accepted by the IRS. This is critical as you must be consistent in your accounting method and must follow the accounting principles in accordance with that recognized method. Otherwise, your return will likely be inaccurate and invite unwanted IRS scrutiny.
Calculating Your COGS
- Inventory at the beginning of the year. If you manufacture goods, this is the total cost of raw materials, unfinished goods, finished goods, and materials and supplies. If your business sells goods, this is the cost of all the goods you have on hand at the beginning of the year. This number is generally the same as the end of the year cost that your business reported in the previous year. If it is not the same, you will need to explain why.
- This does not apply to purchases of personal property, but all raw materials and merchandise that your business purchased during the year for purpose of manufacture or resell.
- Cost of labor. This generally only applies to businesses that manufacture goods. It may include both direct and indirect labor, so long as the labor is necessary to the business’ manufacturing process.
- Materials and supplies. Applicable to manufacturers, materials and supplies are different than raw materials, but are used in the manufacturing process. This may include hardware or chemicals.
- Other costs. These are costs, such as overhead expenses, which includes insurance, utilities, rent, maintenance, depreciation, and taxes. It may also include other costs that are normal for your industry, but are not otherwise classified as purchases, cost of labor, materials, or supplies.
- Inventory at the end of the year. This is the value of your business’ closing inventory (which will also be your next year’s beginning inventory).
To calculate your cost of goods sold, you will take the total of your beginning inventory, purchases, labor costs, materials and supplies, and other costs, then subtract your closing inventory.
You Need an Attorney
Of course, this is just an overview of calculating COGS. Actually calculating your COGS is a much more complex and intense process, which is why you should consult with a tax professional if in doubt. If you need tax advice for your business, contact the Law Office of Robert S. Thomas. I have over twenty years of experience in IRS taxation and want to help you make smart, fully informed decisions. Contact our office today at 847-392-5893 to schedule a consultation or visit our website today