December 21, 2019
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.
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 COGS feature 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.
This is a step by step sample process which calculates Cost of Goods Sold for just one product.
The COGS equation is as follows:
Starting inventory + Any Additional inventory - Final inventory = COGS
$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.
At this stage, you have to calculate what your direct costs are. These can include the following:
You also have to calculate the amount of indirect costs you incurred. These include:
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!
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.
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.
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.
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.
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.
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.