What Is Cost of Goods Sold (COGS)?
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Talk to our experts- Cost of goods sold
- Cost of goods sold (COGS) is what the goods a business sold during a period cost it to buy or make. The IRS figures it as beginning inventory plus purchases, labor, materials and other costs, minus ending inventory. Subtracting it from net receipts gives gross profit, which a business determines before deducting business expenses.
Also called: COGS
How it works
The IRS sets out the cost of goods sold calculation on lines 35 to 42 of Schedule C (Form 1040):
- Beginning inventory: for a merchant, the cost of merchandise on hand at the start of the year that you will sell. For a manufacturer, it also includes raw materials, work in process, finished goods, and materials and supplies used in manufacturing.
- Plus purchases: for a merchant, the cost of all merchandise bought for sale. For a manufacturer, the cost of all raw materials or parts bought to make the finished product.
- Plus cost of labor, materials and supplies, and other costs.
- Equals cost of goods available for sale.
- Minus ending inventory: the value of closing inventory, which usually becomes next year's beginning inventory.
- Equals cost of goods sold.
To figure COGS, you must value your inventory at the beginning and end of each tax year.
What COGS includes
The IRS rules show where distributors and manufacturers differ:
- Freight-in: freight-in, express-in and cartage-in on raw materials, production supplies and merchandise bought for sale are all part of COGS.
- Discounts: you use the prices you actually pay, not the stated prices, so trade discounts lower your cost of purchases. Purchase returns and allowances come off total purchases.
- Labor: usually part of COGS only in a manufacturing or mining business. The IRS says small merchandisers, such as wholesalers and retailers, usually do not have labor costs that can properly be charged to COGS.
- Manufacturing overhead: rent, heat, light, power, insurance, depreciation and similar expenses that are direct and necessary expenses of the manufacturing operation are included.
- Containers: packaging that is an integral part of the manufactured product is included. Packaging that is not is a shipping or selling expense.
FIFO vs. LIFO: how inventory methods change COGS
When you cannot match each item to its actual cost, the IRS lets you identify cost with FIFO or LIFO:
- FIFO (first-in, first-out): assumes the items you bought or made first are the first you sold.
- LIFO (last-in, first-out): assumes the items you bought or made last are the first you sold.
In times of inflation, LIFO produces a larger cost of goods sold and a lower closing inventory, and FIFO the opposite. When prices fall, the effect reverses. Inventory can be valued at cost, at the lower of cost or market, or by the retail method.
Example
An electrical distributor closes its year with these figures:
- Beginning inventory: $200,000
- Purchases, including freight-in: $650,000
- Ending inventory: $230,000
Goods available for sale are $200,000 + $650,000 = $850,000. Cost of goods sold is $850,000 minus $230,000 = $620,000. With $900,000 in net receipts, gross profit is $900,000 minus $620,000 = $280,000, and gross profit divided by net receipts is about 31%. As a wholesaler, it charges no labor to COGS: under the IRS rules, labor costs that cannot properly be charged to COGS can be deducted as selling or administrative expenses.
On Shopify
Shopify reports profit from the cost per item you record on each product or variant. If you resell a product, Shopify suggests entering the price you paid the manufacturer, excluding taxes, shipping or other costs. If you make it, enter a value based on your labor and material costs. Variants each need their own cost. Note that this suggested cost leaves out shipping, while the IRS counts freight-in on merchandise bought for sale as part of COGS.
- Profit reports: gross profit by product, by product variant and by POS location, plus profit margin by order. Gross profit is net sales minus cost, and gross margin is (net sales minus cost) divided by net sales, times 100.
- Cost at time of sale: profit is reported only for products and variants that had a cost recorded when they were sold.
- Static data: the cost per item field holds static data. For dynamic reporting, one option Shopify lists is running financial reports in another business system, such as an ERP or accounting system.
How Uncap helps
Uncap Connect keeps a Shopify store and its ERP in real-time, two-way sync, so pricing, inventory, customers, and orders stay current on both sides. The ERP stays the system of record.
Sources
Frequently asked questions
How do you calculate cost of goods sold?
Add beginning inventory, purchases and production costs to get the cost of goods available for sale, then subtract ending inventory. For example, $200,000 + $650,000 minus $230,000 = $620,000.
What is the formula of COGS?
Beginning inventory plus purchases, labor, materials and supplies, and other costs, minus ending inventory, equals cost of goods sold. These are lines 35 to 42 of Schedule C (Form 1040).
What is excluded from COGS?
Under IRS rules, labor costs that cannot properly be charged to COGS can be deducted as selling or administrative expenses, and small wholesalers and retailers usually have no labor costs that can properly be charged to COGS. Packaging that is not an integral part of a manufactured product is a shipping or selling expense.
What do you mean by cost of goods sold?
It is the cost of the goods a business sold during a period, whether it bought them for resale or made them. Subtracting it from net receipts gives gross profit.
