Cost of goods sold can be a difficult concept for small businesses. It is the one expenditure of your business which does not follow the rules of cash basis accounting, where you deduct expenses when you pay for them. You have to calculate the value of your inventory (unsold merchandise) at year end and use your beginning and ending inventory amounts to calculate your cost of goods sold.
Let’s start by looking at what is cost of goods sold. If your business is engaged in producing merchandise to sell (manufacturing) or buying and reselling merchandise (retailer/wholesaler), you have cost of goods sold, COGS. COGS is the COST of the stuff you sell. If you manufacture products, COGS will include all the direct materials and in some cases labor and overhead that are required to make your product. It usually does not include general supplies and materials that are used up in the operation of your business unless those materials are directly used to produce the final product. If you are a retailer or wholesaler, COGS is the price you pay your supplier for the products you sell. Sometimes COGS may include other costs related to acquiring products such as commissions, taxes, duties or fees that you are required to pay to purchase the products or materials.
COGS does NOT include fees and expenses you pay to SELL the product. Those are selling expenses and should be categorized as such on your profit and loss statement. It is also quite possible that your business does not even have COGS. If your primary business activity is selling a service and not a product, it is very likely that you should not have any cost of goods.
I hear business owners say that cost of goods sold is a big number for their business and they want to “dump” everything they can in there, so the IRS won’t notice it. Let me explain why that is not only bad accounting, but a bad idea. If you have COGS in your business, you also have a number called gross profit. Gross profit is very simply revenue minus COGS. It is the business profit left to pay the other expenses of the business after merchandise is sold. The next number you need to know is your gross profit margin. Gross profit margin is the business’s gross profit divided by revenue. The formula looks like this (revenue – cost of goods)/revenue = gross profit margin. Gross profit margin is shown as a percentage. The algebra whizzes in the crowd already figured out that the more “stuff” you put into COGS the lower your gross profit margin will be.
On Schedule C, you are required to put a business activity or NAICS code. The IRS processes millions of tax returns every year and their computers group the information from all these returns by activity code. One of the bits of information they calculate is average gross profit margin for all the various NAICS codes. The gross profit margin for each individual returns is then compared to the average for that business’s NAICS code. They are NOT looking for folks that have a high gross profit margin, but instead want to identify businesses that have an unusually LOW gross profit margin.
When you have a question if an expense is deductible, I suggest you consult with a tax professional. The worst thing you can do is try to “hide” expenses in cost of goods. By increasing your COGS above the norm for your industry, you are actually increasing the chance that your tax return get’s audited.
To summarize-Cost of Goods Sold is the cost to produce or acquire the products that you sell.
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