How to Properly Report Your Company’s COGS

Do you own a business that manufactures or sells physical goods? For these businesses, accurate reporting of the cost of goods sold (COGS) is essential to determine taxable income and maximize deductions. Miscalculations can lead to overstated profits, higher-than-expected tax bills and even IRS audits.

What's the COGS?

The COGS, also known as the cost of sales, reflects the direct costs to produce or acquire goods sold during the accounting period. According to recent discussions by the Financial Accounting Standards Board's Investor Advisory Committee, the COGS can account for as much as 70% of a company's expenses on its income statement.

The COGS generally includes:

• Direct labor,
• Direct materials,
• Allocations of manufacturing overhead and
• Freight and shipping costs (to ship to your company, not to ship finished items to your customers).

It excludes:

• Indirect costs, including sales, marketing and distribution expenses,
• Administration expenses and general overhead, such as management compensation, facilities costs (rent or mortgage) and utilities and
• Costs related to purchasing or manufacturing unsold goods.

The COGS is deducted from revenue to determine a company's gross profit.

Why Does It Matter?

An accurate COGS is a prerequisite for obtaining an accurate picture of your company's profitability, including which goods boost your bottom line and which hurt it. Accurate COGS calculations can also help control costs and improve decision-making on matters such as pricing, production and inventory management.

Additionally, the COGS affects a company's federal income taxes. Sole proprietors report the COGS on Form 1040, Schedule C, "Profit or Loss From Business." C corporations, S corporations and partners report the figure on Form 1125-A, "Cost of Goods Sold." Generally, the higher your COGS, the lower your profits and taxable income will be.

How Is It Calculated?

The COGS equals the beginning inventory plus purchased inventory less ending inventory. Beginning inventory is the inventory remaining from the previous accounting period, or goods that went unsold during that period. It includes all stock, raw materials, work in progress and finished goods on hand.

The beginning inventory should equal the ending inventory from the previous period. Ending inventory is best computed through a physical count at the end of every period. It's reported on the balance sheet as a current asset item (generally labeled inventory).

What Accounting Method Should We Choose?

The inventory accounting method you choose can have a significant effect on your COGS calculation. The three most common inventory methods are:

1. FIFO. The first-in, first-out (FIFO) method assumes your business sells its inventory in the order in which it was purchased or manufactured. Items that remain in the ending inventory when the period closes are the most recently purchased or manufactured, which typically are the highest-priced items. The older (usually lower-cost) items are the first charged to the COGS. The COGS tends to be lower under FIFO, resulting in higher taxable income and income tax liability.
2. LIFO. The last-in, first-out (LIFO) method assumes you sell your most recently purchased or manufactured items first. The ending inventory consists of the older (usually lower-cost items), with the newer (usually more expensive) items charged first to the COGS. That generally increases your business's COGS and reduces taxable income and income tax liability.
3. Average-cost. This method values inventory using the average price of all goods in stock, regardless of their purchase or manufacturing date. It creates a smoothing effect, preventing the COGS from surging or plummeting due to dramatic, but perhaps temporary, changes in the costs to purchase or manufacture goods.

How Can You Ensure Accurate Reporting?

If your ending inventory for the period is mistakenly overvalued, the COGS will be artificially low, and net income—and your tax liability—will be inflated. You run the same risk if you allocate too much manufacturing overhead to COGS, overstate discounts or returns or forget to write off obsolete goods. Conversely, an inflated COGS figure could lead you to underpay your taxes, with the potential for costly penalties and interest.

To mitigate the risk of inaccuracy in your company's COGS:

• Stay on top of materials prices, which can fluctuate from period to period—never simply rely on historical prices,
• Maintain separate accounts for the COGS and operating costs to reduce the odds of misclassification,
• Pick an inventory accounting method and stick with it,
• Conduct regular inventory counts to reconcile actual inventory with your records and
• Keep supporting documentation for the COGS, including purchase orders, invoices and labor cost tracking.

It's also important to adjust inventory balances for obsolescence and shrinkage due to theft, spoilage or damage. Create supporting documentation—such as photos or insurance claims—for these adjustments.

The Bottom Line

Your company's COGS is a critical financial metric with direct implications for your tax obligations. However, capturing the proper costs accurately can be complicated. Contact your SSB financial advisor for guidance on how to report costs according to the current tax and accounting rules and how to implement inventory-management best practices.

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