Cost of Goods Sold
If you sell physical products, COGS is how you tell the IRS what it cost to produce what you sold. Understanding inventory valuation is the difference between accurate profit and an audit red flag.
A guide by Taxstra Tax & Accounting — CPA-led tax strategy for business owners
Cost of Goods Sold (COGS) represents the direct costs of producing the goods sold by your business. The IRS subtracts COGS from your Gross Receipts to arrive at Gross Profit — the top line before operating expenses. For product-based businesses, getting COGS right is as important as getting every other expense line right combined.
The COGS Formula
Schedule C Part III walks you through the calculation step by step. The formula never changes:
The Small Business Inventory Exception
The Tax Cuts and Jobs Act (TCJA) gave small businesses a meaningful simplification option.If your average annual gross receipts for the prior three years are under $29 million (adjusted for inflation), you can elect out of the normal inventory accounting rules under Section 471.
Option 1: Non-Incidental Materials & Supplies
Treat inventory as "materials and supplies." Deduct them when used or consumed — or when paid for, whichever is later. This is simpler than tracking beginning and ending inventory balances precisely.
Option 2: Cash Method Conformity
If your financial statements already expense inventory immediately (cash basis bookkeeping), your tax return can follow that treatment in certain circumstances.
Common COGS Mistakes
Double-Dipping Supplies
A common error: listing raw materials or product costs in COGS (Part III) and also on Line 22 (Supplies) in Part II. You can only deduct a cost once. Direct product materials belong in COGS; general office supplies like paper, pens, and printer ink belong on Line 22.
Inflating Purchases with Capital Assets
The "Purchases" line in COGS is for items bought specifically for resale or raw materials used to make your product. Equipment, computers, furniture — anything that will last more than a year — is a capital asset that belongs in the depreciation section (Line 13), not COGS. Including a $3,000 laptop in COGS inflates your cost of goods and understates profit incorrectly.
Audit Defense: Inventory Documentation
Inventory is one of the first things an auditor examines in a product-business audit. Good records turn a months-long examination into a straightforward document review.
Year-end physical count
Count your inventory on December 31 (or as close as possible). Keep a dated spreadsheet showing item, quantity, and unit cost. Sign and date it. This is your ending inventory number.
Supplier invoices
Every purchase of resalable inventory should have a corresponding invoice or receipt showing cost, quantity, and date. Store these by vendor.
Inventory tracking system
Even a simple spreadsheet tracking purchases, sales, and running balance is far better than reconstructing records from memory during an audit.
Consistent costing method
Pick FIFO, LIFO, or specific-identification and use it every year. Changing methods requires IRS Form 3115 and approval.
Example Fixed Asset Log
| Item | Date Purchased | Cost | Business Use % |
|---|---|---|---|
| MacBook Pro | 06/15/2024 | $3,200 | 100% |
| Camera Lens | 08/20/2024 | $1,500 | 100% |
| Office Desk | 01/10/2024 | $850 | 100% |
Frequently Asked Questions
Questions About Your Product Business Taxes?
A Taxstra CPA can review your inventory method, COGS calculation, and any year-end tax strategies for product-based businesses.
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