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. 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.

Cash Method and Inventories. As mentioned earlier, not every business is eligible to use the cash method. The most significant exception applies to businesses that have inventory. However, most small businesses qualify for an exception to this prohibition.

Gross Receipts of $1 Million or Less. You are not required to use inventories or the accrual method of accounting if you have average gross receipts (income from your business) of $1 million or less for the three most recent tax years. To determine if you qualify for this exception in 2012, add your gross receipts for 2009, 2010 and 2011 and then divide by three. You qualify for the exception if the resulting amount is $1 million or less.

Gross Receipts of $10 Million or Less. If your average annual receipts are greater than $1 million, you may still be able to qualify for an exception to the requirement that you use inventory accounting. To qualify under this second exception, you must have average gross receipts of $10 or less for the three most recent tax years and your business must be considered a "qualifying business." A business is a "qualifying business" if it meets any one of the following definitions:

• your principal business activity is not retailing, wholesaling, manufacturing, mining, publishing, or sound recording.
• your principal business activity is providing services, even if your customer receives property incidental to the services.
• your principal business activity is custom manufacturing

You can also use this safe-harbor for a business that is not your primary business, if it meets one of the these three definitions.

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

		Inventory at beginning of year
+		Purchases or additions during the year
=		Goods available for sale
-		Inventory at end of year
=		Cost of goods sold

If you are a sole proprietor filing Schedule C, this equation is the basis for Part III on the back of the Schedule C. Your 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 using either of the small business exceptions discussed above, then your calculation is much simpler. See the Instructions for Schedule C for the method that you need to use.

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. As done with the usual inventory additions and purchases during the year, a manufacturer would report the cost of raw materials or parts purchased for manufacture into a finished product. 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 a better way to evaluate your inventory?
• How do you identify the inventory items that were sold?