Cost of goods sold: what it is and how to calculate COGS

What is cost of goods sold

Cost of goods sold is the cost of the products that actually left your shop during the year. For a maker, that means the wax, fabric, clay, jars and labels that went into the items you sold, plus the share of inventory you used up. It does not include the cost of products still sitting on your shelf at year end.

The IRS says that if you make or buy goods to sell, you can deduct the cost of goods sold from your gross receipts on Schedule C (Form 1040). To work out that figure, you must value your inventory at the beginning and end of each tax year. This is why COGS and inventory are tied together: the year-end count decides how much of what you bought counts as sold.

The rules are for product businesses. Publication 334 says its cost of goods sold chapter does not apply to a personal service business, such as a painter or a lawyer. A candle maker, a jeweler or a print seller is in scope; a pure service business usually is not.

The cost of goods sold formula

The formula has three parts: what you had at the start, what you added during the year, and what was left at the end.

Cost of goods sold = beginning inventory + purchases + labor + materials and supplies + other costs − ending inventory.

Schedule C uses exactly this order. The IRS describes the total of the first five lines as the cost of the goods available for sale during the year. When you subtract your closing inventory, the remainder is your cost of goods sold during the tax year.

What is included in cost of goods sold

The test is whether a cost goes into the product or into running the business. Raw materials, product packaging and the freight you pay to get materials to you are product costs. Ads, marketplace fees and shipping to customers are business expenses that go elsewhere on Schedule C.

Overhead can belong in COGS for some producers. Publication 334 says overhead that you have as direct and necessary expenses of the manufacturing operation is included in cost of goods sold. Small sellers who buy finished goods to resell usually have no labor in COGS: the IRS notes that small merchandisers usually do not have labor costs that can properly be charged to cost of goods sold.

How to calculate cost of goods sold, step by step

These steps follow the Schedule C lines in order. Keep receipts and the count sheets behind each figure.

1. Find your beginning inventory

   Opening inventory will usually be identical to the closing inventory of the year before. For a maker, it covers the total cost of raw materials, work in process, finished goods, and materials and supplies used in manufacturing the goods. If the number differs from last year's closing figure, you must explain any difference in a schedule attached to your return.

2. Add up purchases for the year

   Total the materials and parts you bought for products. You must use the prices you pay (not the stated prices), and you must deduct all returns and allowances from your total purchases. If you took finished items home for yourself or as gifts, you must exclude this cost from the total amount of merchandise you bought for sale.

3. Add labor, supplies and other costs

   Add wages paid to people who make the product, supplies used up in making it, product packaging and freight-in. Leave out anything you paid yourself, and leave out shipping supplies for customer orders.

4. Count what is left at year end

   Count finished pieces, work in process and raw materials on hand on the last day of the tax year, and value them. Publication 538 adds that You must take a physical inventory at reasonable intervals.

5. Subtract ending inventory

   Line 40 minus your closing inventory is your cost of goods sold. Enter the result here and on line 4, where the IRS tells you to subtract the cost of goods sold (line 4) from net receipts (line 3) to get gross profit.

A worked example: COGS for a candle maker

Example: a candle maker files for one calendar year. The figures below are made-up example inputs, not IRS amounts, and show how the formula fits together.

In the example, $6,300 goes to line 4. If the same maker had sales of $18,000 and no returns, gross profit would be $11,700 before any business expenses. The IRS says You must determine gross profit before you can deduct any business expenses, so ads, marketplace fees and shipping supplies come off after this step.

The $1,100 count on December 31 becomes next year's beginning inventory. To turn the yearly figure into a price check per item, divide materials by units made, as in the cost per unit guide.

Inventory and cost of goods sold

The Schedule C instructions say that when making or selling goods is how you earn, in most cases you must take inventories into account at the beginning and end of your tax year. Your inventory should include raw materials, work in process, finished products and Supplies that physically become a part of the item intended for sale. Publication 538 lists Supplies that do not physically become part of the item intended for sale among the items you leave out.

To put a cost on what is left, Publication 538 describes ways to identify cost. Use specific identification when you can identify and match the actual cost to the items in inventory. If identical materials are mixed together, the FIFO method assumes the items you purchased or produced first are the first items you sold.

Cost of goods sold for small business: the simpler option

Very small sellers do not always have to keep a formal inventory. If you qualify as a small business taxpayer, you can choose not to keep an inventory, but you must still use a method of accounting for inventory that clearly reflects income. One part of that test is average annual gross receipts of $31 million or less for the 3 prior tax years, and the other is that you are not a tax shelter.

One allowed approach treats inventory as materials and supplies that are not incidental. Under it, you deduct what you paid for the inventoriable items in the year in which they are first used or consumed in your operations, rather than when you buy them. Leftover materials at year end are still not deducted until you use them.

Line 33 asks how you value closing inventory. The instructions allow cost, the lower of cost or market, or any other method approved by the IRS. If you want to switch methods later, the instructions say to file Form 3115.

Cost of goods sold vs expenses

Cost of goods sold and business expenses are both deductions, but they sit in different places and follow different timing. COGS is figured in Part III and lands on line 4, before gross profit. Expenses such as advertising, platform fees, software and postage go in Part II and come off gross profit.

Timing is the main difference. A product cost reaches line 4 only when the product sells, through the inventory count. Wax bought in December and still on the shelf on December 31 stays in ending inventory and reduces next year's COGS instead.

Form 1099-K does not include your costs

Payment apps and online marketplaces must send a Form 1099-K when your payments for goods or services total over $20,000 in more than 200 transactions. They may send you a Form 1099-K with lower amounts and/or transactions. The current threshold comes from the One, Big, Beautiful Bill, which retroactively reinstated the reporting threshold in effect prior to the passage of the American Rescue Plan Act of 2021. Guides written before that law may quote a lower figure.

The form shows gross payments only. The IRS says the gross payment amount does not account for the original purchase price, or basis, of any items sold. Your cost of goods sold is what brings those gross payments down to gross profit, so keep the purchase records that support it.

Schedule C is a federal form, and the instructions note: You may be subject to state and local taxes and other requirements such as business licenses and fees. State income tax rules on inventory can vary by state, so check your state's rules as well.

Where Nation fits

Questions about cost of goods sold