Computing Your Cost of Goods Sold

If your business makes or buys goods to sell and maintains an inventory, you're entitled to deduct the cost of goods sold from your revenues in computing your taxable income.

It's a given that all manufacturers, retailers, and wholesalers must use an inventory to accurately track their costs unless they qualify for the exception as a small business. Other types of businesses, such as those providing professional services or working in the trades, will need to use inventory accounting methods if they bill customers separately for materials and supplies. And under IRS rules, most businesses that use inventory must use accrual accounting, at least for purchases and sales of inventory items.

Did You Know? Qualifying small business taxpayers whose average annual gross receipts for the prior three tax years are $1 million or less, or in certain cases over $1 million up to $10 million, may qualify for a less burdensome accounting method for their inventory costs. Under this method, inventory costs of raw materials purchased for use in producing finished goods and merchandise purchased for resale are deductible in the later of the year the items are sold or paid for. See Accrual Method Accounting for additional information.

In general terms, the formula used to compute your cost of goods sold is the following:

If you are a sole proprietor filing Schedule C, this equation is the basis for Part III on the flip side of the Schedule C. Inventory at the beginning of the year is reported on Line 35, purchases are reported on Line 36 (with a reminder to subtract the cost of items you withdrew for your own personal use), goods available for sale appears on Line 40, inventory at the end of the year is reported on Line 41, and the result is your cost of goods sold on Line 42.

If you are a reseller of goods, these would be the only five items you need. But if you are a manufacturer, things get a little more complicated.

Inventory methods for manufacturers. A manufacturer would report the cost of raw materials or parts purchased for manufacture into a finished product as purchases or additions during the year. You would also report the cost of labor on Line 37, including both direct labor costs for production workers, and indirect costs for other employees who perform a general factory function that is necessary for the manufacturing process. On Line 38 you would report the cost of materials and supplies used in the manufacturing process such as hardware, lubricants, abrasives, etc. And on Line 39 you would report the cost of overhead, which includes rent, utilities, insurance, depreciation, taxes, and maintenance for the production facility, as well as the cost of supervisory personnel.

In their accounting records, small manufacturers traditionally use three categories of inventory: raw materials, work in process, and finished goods awaiting sale. As raw materials are purchased, their costs (including delivery charges) are debited to the raw materials account. As materials are taken from storage and used in the manufacturing process, their costs are removed from (credited to) raw materials and added (debited) to the work in process account. The work in process account also collects the costs of direct and indirect labor and factory overhead. When the goods are finished, their costs are transferred (credited) out of work in process and added (debited) to the finished goods inventory. By taking beginning and ending counts of items in each of these three types of inventories, manufacturers can keep a handle on their costs.

Inventory valuation methods. Whether you are a retailer or a manufacturer, how do you determine the numbers to plug into the inventory equation?

As a starting point, you need to determine the number of items in your inventory (or each category you use) at the beginning and end of each year. You don't need to physically count your inventory at the end of the year, although that would be the most accurate way to do it. The IRS recognizes that requiring every business to do a complete inventory count on December 31 would be unworkable and would result in poor information, since workers would be rushed and not likely to make an accurate count.

As long as you take regular physical inventory counts at intervals during the year, you may extrapolate your beginning/ending amounts. The inventory at the end of year 1 becomes the beginning inventory for year 2; if there is a discrepancy, you should attach an explanation to your tax return.

But once you know the number of each kind of item in your inventory, how do you determine the value of the inventory at the beginning and at the end of the year, which in turn will determine the value of inventory items sold during the year?

There are two issues that need to be addressed before you can answer that question:

• Is cost or market value the better way to evaluate your inventory?
• How do you identify the inventory items that were sold?

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