What expense category is Cost of Inventory Expenses?

For any business that buys or manufactures goods to sell, managing the cost of that inventory is the single most important factor in determining profitability. For accountants and small business owners, it's also one of the most distinct areas of tax accounting.

Unlike other business expenses that are deducted directly from income, the cost of inventory is handled through a specific calculation called the Cost of Goods Sold (COGS). Understanding how to correctly calculate COGS is essential for accurately reporting your gross profit and ensuring your tax return is compliant with IRS rules. This guide will break down the process.

The Cost of Goods Sold (COGS) Category

The "Cost of Inventory" is not a standalone expense category you deduct directly. Instead, it is the primary component of the Cost of Goods Sold (COGS) calculation. COGS represents the direct costs of the merchandise that a business has sold during a year.

This figure is not listed alongside other business expenses like rent or advertising. Instead, it is subtracted directly from your business's gross receipts to determine its gross profit. This calculation is fundamental to your income statement and tax return.

How to Calculate Cost of Goods Sold

If the production, purchase, or sale of merchandise is an income-producing factor in your business, the IRS requires you to take inventory into account at the beginning and end of each tax year. This is done using the COGS formula.

The basic formula to figure your Cost of Goods Sold is:

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

Let's break down the key components of this calculation.

What to Include in COGS

• Purchases: This is the cost of all merchandise you buy for resale. For manufacturers, it includes the cost of all raw materials or parts purchased to manufacture into finished products. You must subtract the cost of any items withdrawn from inventory for personal use.
• Cost of Labor (for manufacturers): This includes the wages you pay to employees who spend their time working directly on the product being manufactured.
• Materials and Supplies (for manufacturers): This includes the cost of any supplies that physically become a part of the item you are manufacturing.
• Other Costs: This category includes costs directly related to acquiring or producing inventory, such as:
  
  • Freight-in: The cost of shipping and freight to get materials or finished goods to your business is included in COGS.
  • Factory Overhead: For manufacturers, this includes costs like rent, heat, light, and power for the factory space.

Examples of Costs Included in Inventory (COGS)

The specific costs that are part of your COGS calculation will depend on your business, but they generally include:

• The cost of finished products purchased for resale from a supplier.
• The cost of raw materials, such as wood for a furniture maker or fabric for a clothing brand.
• Freight and shipping charges to have materials delivered to you.
• Direct labor costs for production employees.
• Storage costs for inventory.

Tax Implications of Cost of Inventory Expenses

Reporting COGS on Your Tax Return

Cost of Goods Sold is not deducted on the "Expenses" part of your tax return. For sole proprietors, COGS is calculated on Part III of Schedule C (Form 1040). The final COGS amount from line 42 is then entered on line 4 and subtracted from gross receipts to figure gross profit.

If you include an expense in the Cost of Goods Sold, you cannot deduct it again as a business expense.

Inventory and Accounting Methods

If you are required to account for inventory, you must generally use an accrual method of accounting for your purchases and sales. However, an exception exists for qualifying small business taxpayers, who may be able to use the cash method and can treat their inventory as non-incidental materials and supplies.

Recordkeeping for Substantiation

You must keep detailed and accurate records to support your COGS calculation. These supporting documents are essential for an audit and include:

• Invoices and paid bills for all purchases of merchandise and raw materials.
• Canceled checks or other proof of payment for all inventory-related items.
• Freight bills for shipping charges.
• Accurate inventory count sheets from the beginning and end of the year.

Automate Your Inventory Cost Tracking with Fyle

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: With every invoice, receipt, and payment record attached to its corresponding transaction, Fyle creates a centralized, compliant system of record to fully substantiate your COGS calculation.

Focus on managing your inventory, not the paperwork behind it.