Cost of Goods Sold Explained for Tax Returns

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The cumulative cost of selling a particular product is called Cost of Goods Sold (COGS). It varies from product to product and increases with factors such as complexity of the manufacturing process or the cost of raw material. The volume of the product manufactured can also have a direct impact on the overall Cost of Goods Sold.

It is an important figure because you will need it when filing your tax returns. Adding it to the equation will reduce your total income, hence giving you a certain advantage. Unfortunately, calculating this cost of goods sold is not as simple as it sounds. Getting it right is crucial to getting your taxes right.

How Can You Calculate the Cost of Goods Sold?  

Quite naturally, the calculation of the Cost of Goods Sold varies from product to product. There are many factors to consider. It is in the best interest of your business to work with a CPA or a tax professional in order to accurately calculate the cost of your business income tax returns.

The first thing you need is the beginning amount and the inventory amount plus the cost of all the inventory purchased that year. There are different evaluation methods. You should talk to your CPA to know which one they will be using. This will give you a better idea of components you need for the actual calculation.

What Are the Essential Components for the Calculation of the Cost of Goods Sold

The first step is to identify and analyze the following components.

  • Cost of inventory at the beginning of the year
  • Cost of inventory purchased during the year
  • Inventory left at the end of the year

The sum of the first two components minus the last component will get you the Cost of Goods. It doesn’t matter if you are a manufacturer or re-seller, this calculation will help you deduce both the direct and indirect cost of goods sold.

Direct and Indirect Costs – In the next step, direct costs and indirect costs are calculated.

The direct costs include the cost of raw material, cost of merchandise, packaging costs, cost of supplies for production, and direct overhead costs involved in the production.

The indirect costs include labor cost, storage cost, salaries, equipment cost, as well as the cost of depreciation. Facilities costs include mortgage, rent, utilities, etc. This is perhaps the most complicated part of the entire process. It is quite impossible for any business to determine these costs without the help of a CPA.

The LIFO and FIFO Methods

LIFO and FIFO are ways to calculate the inventory that is left at the end of the year. The IRS is very critical of the valuation method you use. In case you decide to use a different valuation method than the previous year, you will need to seek approval from the IRS.

Different COGS calculation forms are used for different types of businesses. For instance, sole proprietors use Part III for calculation and include the cost in income section part I. Corporations or partnerships use the Form 1125A. This may be a complicated process and best left to professional CPAs.

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