When the calendar switches to a new year, business owners from all over the United States breathe a collective sigh. You can almost hear it. This tells you that it's almost time to deal with terms such as Cost of Goods Sold during tax season.
This is not exactly the most popular time of year for many business owners. It is that time of year when invoices, receipts, and other financial records are gathered together, so these entrepreneurs can see how much they owe the government.
Online businesses are not immune to this. You probably are feeling the same pressure as tax time gets nearer and nearer. When I first started selling on Amazon, I was told “cost of goods sold" is an important term to understand.
What the heck does cost of goods sold mean? This article defines what the term means, how it's calculated, and how to estimate, for tax purposes, your inventory value.
- Step 1: What goes into a COGS calculation?
- Step 2: Defining your direct costs
- Step 3: Defining your indirect costs
- Step 4: Calculating your facilities costs
- Step 5: Determining your initial inventory
- Step 6: Adding the cost of inventory purchases
- Step 7: Calculating your ending inventory
- Step 8: Determine your COGS
Defining the Cost of Goods Sold Formula
Business tax returns require that you supply COGS (cost of goods sold). This amount reduces your business income. It has the effect of DECREASING the amount of business taxes you have to pay.
It is important that you get this number right so you can reduce your tax liability. WOHOOO!!!
To calculate COGS formula, you have to take into account all the costs involved in producing or buying the products you have sold. Calculating these expenses can get quite messy. This is especially true if you manufacture or sell many different product lines.
What follows is a step by step guide that helps you calculate COGS. This is a manual process.
If you already chose automated tools like the inventory control software we offer at taxomate, you should still read the information below. It gives you a clear understanding of the COGS concept and the numbers you need to calculate it.
Calculating Cost of Goods Sold
This is a step by step sample process which calculates Cost of Goods Sold for just one product.
Step #1: What goes into a COGS calculation?
The COGS equation is as follows:
Starting inventory + Any Additional inventory - Final inventory = COGS
Quick Example:
$20,000 (the year starting cost of inventory) + $10,000 (inventory bought and added to existing stock for the rest of the year) - $20,000 (inventory available at the end of the year) = $10,000 (this is your cost of goods sold)
COGS calculation enables you to deduct the product costs of the inventory you move. It doesn't matter whether you are a retailer or an actual manufacturer.
Understanding Direct and Indirect Costs
COGS has two components - direct and indirect costs.
Direct costs relate to expenses incurred when you purchase or produce your products. Indirect costs are expenses tied to the processes associated with selling your products. This can include equipment, labor, facilities, and storage.
Step #2: Defining your direct costs
At this stage, you have to calculate what your direct costs are. These can include the following:
- The cost of completed product inventory
- Direct expenses you have to pay due to production-related overhead
- The value of the supplies you had to buy to produce your products
- Cost of packaging
- The raw material costs to manufacture your product
- The amount you had to pay to acquire products so you can resell them
Step #3: Defining your indirect costs
You also have to calculate the amount of indirect costs you incurred. These include:
- Depreciation value of the equipment you used to package, produce, process or store your product
- Equipment administrative costs (these are expenses related to equipment that is not associated with the production processes)
- Administrative labor expenses (these are paid to people who supervise the production process)
- Costs of storage
- General labor costs (these cover the wages of any production employees you may hire. This also includes temporary workers)
Step #4: Calculating your facilities costs
Usually, this step is best handled by a trained tax professional or CPA. Facilities costs are quite tricky and hard for lay people to calculate.
Complicating things is the fact that a certain percentage of expenses related to facilities involved in production is prorated to each unit of product you produce. This can include anything from utility costs, mortgage interest, rent, etc. Best to leave this one to the pros!
Step #5: Determining your initial inventory
This figure is pretty straightforward. This is just your inventory you had from the previous year. This figure covers completed units, products in the process of production, as well as stock available for sale.
Step #6: Adding the cost of inventory purchases
This amount is the cost of any product you added to your inventory (after the starting inventory). This can cover manufacturing costs as well as shipping costs of products manufactured by somebody else.
Step #7: Calculating your ending inventory
Ending inventory costs are calculated by physically counting whatever stock you have on hand. Please understand that if you have any obsolete or damaged stock, this can reduce your year-end inventory costs.
Step #8: Determine your COGS
If you've properly calculated the figures for all the previous steps, you should have all the data required to figure out your COGS. You can choose to do this on your own. But if you want to protect yourself, you should have a professional tax preparer assist you.
Let's Calculate the Value of Your Inventory
The last thing you need to do is to choose the valuation method for your inventory. The IRS allows for the following three methods:
1. Retail Method
This is the retail value of the product you offer minus your markup percentage.
2. Cost Value Method
The amount you spent to acquire the item you're going to sell plus the cost of shipping.
3. Lower of Market or Cost Value Method
The IRS allows you to pick the lower figure between the cost of your inventory on a particular date every year or its market value.
Which inventory valuation method should I choose?
Among the three valuation methods above, the easiest to track is No. 2 (Cost method). Most small businesses prefer this method.
On the other hand, if you deal with products that have costs that are very difficult to figure out, you can use either of these following methods to track your costs: FIFO (first in, first out method) or LIFO (last in, first out method).
Consult with your qualified tax professional to see the pros and cons of each of the methods above. They will help you pick the method that would work best in your situation.
What's important is that once you have selected one of these methods, you have to stick to it. Otherwise, you're going to have to get permission from the IRS to switch out of the particular method you have chosen.
Keep these tips in mind:
- COGS deductions only cover items that you have sold. If you bought or produced inventory that has not sold, you could not expense their costs.
- Existing tax regulations do not require small businesses (those that make below $1 million in annual sales) to report their inventory.
- To get more information on inventory valuation and other issues, take a look at IRS Publication 538.
