What happens to cost of goods sold in the profit and loss report when you sell a product?

If your business sells products, you need to know how to calculate the cost of goods sold. This calculation includes all the costs involved in selling products. Calculating the cost of goods sold (COGS) for products you manufacture or sell can be complicated, depending on the number of products and the complexity of the manufacturing process. 

Key Takeaways

• The cost of goods sold is how much a business's products cost to buy or produce.
• A simple formula to calculate the cost of goods sold is to start with your beginning inventory value, add any purchases or other costs, and subtract your ending inventory value.
• The cost of goods sold includes not only the products in your inventory for sale, but also the labor to produce and ship them as well as the parts and materials required to make them.

What Is Cost of Goods Sold?

The cost of goods sold is how much it costs the business to produce the items it sells. The calculation of the cost of goods sold is focused on the value of your business's inventory.

If you are selling a physical product, inventory is what you sell. Your business inventory might be items you have purchased from a wholesaler or that you have made yourself. You might also keep an inventory of parts or materials for products that you make. Inventory is an important business asset, with a specific value.

Note

You most likely will need a tax professional to calculate COGS for your business income tax return. But you should know the information needed for this calculation, so you can collect all the information to include in this report.

Basic Cost of Goods Sold Formula

The basic formula for the cost of goods sold is to start with the inventory at the beginning of the year and add purchases and other costs. From that number, subtract the inventory at the end of the year. Written out, it looks like this:

Beginning inventory + purchases and other costs - ending inventory = COGS

Example of the Cost of Goods Sold Formula

Here's an example of how the cost of goods formula works. Say you have $14,000 in inventory at the beginning of the year. You added $8,000 in materials or products. Your inventory at the end of the year is $10,000. The formula would be $14,000 + $8,000 - $10,000 = $12,000. Your cost of goods sold is $12,000.

What You Need To Calculate COGS

Before you begin, you will need some information:

Accounting Method

The Internal Revenue Service (IRS) requires businesses with inventory to account for it by using the accrual accounting method.

There is an exception to this rule for small businesses. If you are a small business with annual gross receipts of $26 million or less for the past three years, you may be able to choose not to keep an inventory and not use the accrual method for accounting. Check with your tax professional before you make any decisions about cash vs. accrual accounting.

Inventory Cost Method

To use the inventory cost method, you will need to find the value of your inventory. The IRS allows several different methods (FIFO or LIFO, for example), depending on the type of inventory. The IRS has detailed rules for which identification method you can use and when you can make changes to your inventory cost method.

You will also need to gather other information about your inventory:

• Beginning inventory, which must be the same as your ending inventory at the end of the year before.
• Cost of purchases (parts, materials, finished products) for inventory
• Cost of labor (paying employees to make products and ship them)
• Cost of materials and supplies used to create and ship products
• Other costs, including shipping containers, freight costs, and warehouse expenses such as rent, electricity, etc.
• Ending inventory, which is the value of all items in the inventory at the end of the year
  

Steps in Calculating the Cost of Goods Sold

Once you have gathered the relevant information, you can calculate the cost of goods sold.

Step 1: Determine Direct and Indirect Costs

The COGS calculation process allows you to deduct all the costs of the products you sell, whether you manufacture them or buy and re-sell them. List all costs, including cost of labor, cost of materials and supplies, and other costs.

There are two types of costs included in COGS:

• Direct Costs are costs related to the production or purchase of the product
• Indirect Costs are costs related to warehousing, facilities, equipment, and labor

Here's an example of the difference between direct and indirect costs:

• Direct labor cost is wages you pay to employees who spend all their time working directly on the products your company makes, including both full-time and part-time employees
• Indirect labor cost is wages you pay to employees who work in your factory who don't have any immediate or direct connection with making products, including stocking, packaging, and shipping workers

Step 2: Determine Facilities Costs

Facilities costs (for buildings and other locations) are the most difficult to determine. This is where a good tax professional comes in. You must set a percentage of your facility costs (rent or mortgage interest, utilities, and other costs) to each product for the accounting period in question (usually a year, for tax purposes).

Step 3: Determine the Beginning Inventory

Inventory includes the merchandise in stock, raw materials, work in progress, finished products, and supplies that are part of the items you sell. You may need to physically count everything in inventory or keep a running count during the year.

Your beginning inventory this year must be exactly the same as your ending inventory last year. If the two amounts don't match, you will need to submit an explanation on your tax form for the difference.

Step 4: Add Purchases of Inventory Items

Most businesses add inventory during the year. You must keep track of the cost of each shipment or the total manufacturing cost of each product you add to inventory. For purchased products, keep the invoices and any other paperwork. For the items you make, you will need the help of your tax professional to determine the cost to add to inventory.

Step 5: Determine the Ending Inventory

Ending inventory costs are usually determined by taking a physical inventory of products or by estimating.

Ending inventory costs can be reduced for damaged, worthless, or obsolete inventory. For damaged inventory, report the estimated value. For worthless inventory, you must provide evidence that it was destroyed. For obsolete (out of date) inventory, you must also show evidence of the decrease in value.

Note

Step 6: Do the COGS Calculation

At this point, you have all the information you need to do the COGS calculation. You can do it on a spreadsheet or have your tax professional help you.

Cost of Goods Sold on Business Tax Returns

The process and form for calculating the cost of goods sold and including it on your business tax return are different for different types of businesses. 

For sole proprietors and single-member limited liability companies (LLCs) using Schedule C as part of their personal tax return, the cost of goods sold is calculated in Part III and included in the Income section (Part I) of this schedule.

Here's an example of what the calculation would look like on Schedule C for small business taxes:

For partnerships, multiple-member LLCs, corporations, and S corporations, thecost of goods sold is calculated on Form 1125-A. This form is complicated, and it's a good idea to get your tax professional to help you with it. 

Frequently Asked Questions (FAQs)

What does the cost of goods sold mean?

The cost of goods sold tells you how much it cost the business to buy or make the products it sells. This cost is calculated for tax purposes and can also help determine how profitable a business is.

Where can you find the cost of goods sold on an income statement?

You'll typically find the cost of goods sold on the line directly underneath total revenue when looking at a company's income statement. If you subtract the cost of goods sold from total revenue, you'll get the gross profit figure.

How is the cost of goods sold classified in financial statements?

The cost of goods sold is considered an expense when looking at financial statements. That's because it's one of the costs of doing business and generating revenue.

Does cost of goods sold go on profit and loss statement?

What happens to COGS when you sell inventory?

When you sell an item How does it affect the profit and loss report?

How do you determine the profit on the sale of an inventory product?