What expense category is Cost of Goods Sold Expenses?

For any business that manufactures or sells physical products, the term "COGS" is one of the most important metrics in accounting. However, a common point of confusion for new business owners is how to treat these costs. Unlike rent or marketing, the Cost of Goods Sold (COGS) is not a simple expense category; it's a critical calculation that directly determines your company's gross profit and overall financial health.

Understanding the components of COGS and how to calculate it correctly is essential for accurate financial reporting, effective inventory management, and compliant tax filing. This guide will break down the COGS calculation as defined by the IRS and explain its tax implications for your business.

Understanding the Cost of Goods Sold (COGS) Calculation

The Cost of Goods Sold (COGS) is not a standard expense category that you list with your other operating expenses. It represents the total direct costs of producing or acquiring the goods that your business has sold during a specific period.

According to the IRS, if the production, purchase, or sale of merchandise is an income-producing factor in your business, you must use COGS to determine your gross profit. This is calculated by subtracting COGS from your gross receipts.

The Components of the COGS Formula

The IRS provides a specific formula on Schedule C to calculate the Cost of Goods Sold. The basic formula is:

1. Inventory at the beginning of the year
2. Plus: The cost of purchases, labor, materials, supplies, and other costs
3. Minus: Inventory at the end of the year
4. Equals: Cost of Goods Sold

Let's look at each component in more detail.

• Beginning Inventory: This is the value of your inventory on hand at the start of the tax year. It should be the same as your ending inventory from the previous year.
• Purchases: This includes the cost of all merchandise you bought for resale or the cost of all raw materials and parts purchased for manufacturing. You must subtract the cost of any items you withdrew from inventory for your personal use.
• Cost of Labor: In a manufacturing business, this includes the wages paid to employees who spend their time working directly on the product being manufactured.
• Materials and Supplies: For manufacturers, this includes the raw materials and supplies that are physically part of or consumed in the manufacturing process.
• Other Costs: This includes additional costs directly related to your inventory, such as freight charges to have goods delivered to you ("freight-in") and certain overhead expenses like rent and utilities for a factory space.

Examples of COGS Expenses (Costs Included in the Calculation)

The specific costs that are part of your COGS calculation depend on the nature of your business.

For Retailers/Wholesalers:

• The purchase price of the finished goods.
• Shipping costs to acquire the goods from the supplier (freight-in).

For Manufacturers:

• The cost of raw materials (wood, steel, fabric, etc.).
• The cost of supplies that are part of the finished product.
• Direct labor costs for production-line workers.
• Factory overhead, such as rent and utilities for the production facility.

Tax Implications of COGS Expenses

How COGS Is "Deducted" on Your Tax Return

COGS is treated differently from all other business expenses. It is not listed again under the "Expenses" section of your tax return. If you include a cost in COGS, you cannot deduct it again as a separate business expense, like advertising or office supplies.

For sole proprietors, the COGS calculation is performed in Part III of Schedule C (Form 1040). The result from this section is then entered on line 4 and subtracted from your gross receipts to determine your gross profit.

Recordkeeping for Substantiation

To accurately calculate COGS, you must keep detailed and precise records for all its components. Essential supporting documents include:

• Invoices and paid bills for all merchandise and raw material purchases.
• Canceled checks, bank statements, or other proofs of payment.
• Freight bills for all inbound shipping costs.
• Accurate inventory count sheets from the beginning and end of the year.

How Fyle Can Automate Tracking for COGS Components

While COGS is a high-level calculation, its accuracy depends on perfectly tracking every individual transaction for purchases, materials, and freight throughout the year. Manually managing this flow of invoices and receipts is a significant challenge.

Fyle helps businesses automate the tracking of all the underlying expenses that make up the Cost of Goods Sold.

• Automated Invoice Capture: Fyle can automatically capture invoices for materials and supplies directly from your email inbox, ensuring no purchase record is ever lost.
• Real-Time Data from Corporate Cards: When inventory or materials are purchased with a corporate card, Fyle captures the transaction data in real time, simplifying reconciliation and categorization.
• Streamlined Categorization: Easily categorize expenses as "Purchases," "Freight-In," or "Materials" as they happen, giving accountants a clean, accurate data set to work with when calculating COGS at year-end.
• Build Your Audit-Proof Trail: By centralizing every invoice and proof of payment, Fyle builds the robust documentation required by the IRS to substantiate your COGS calculation.

Focus on selling your products, and let Fyle handle the expense management behind them.