What is Cost of Goods and How is It Determined?

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If you are filing taxes for a business that sells goods or products, you will need to report the costs of goods sold on their tax return.

What is the cost of goods sold?

The cost of goods sold (COGS) is the costs directly related to the generation of the products sold by the company. This amount includes direct labor costs and the cost of materials. It does not include distribution costs and sales costs, as well as other indirect expenses such as certain overhead costs. It is also known as the cost of sales or cost of services. It is important to note that the cost of goods sold only applies to expenses relating to products that are intended for sale.

What is Form 1125-A?

Businesses that provide or buy items for sale with the intent to generate income are required to report the cost of the items that are sold accurately.

UseForm 1125-A to calculate the costs of goods sold by these businesses. It is used by business return filers on Form 1065, 1120 or 1120-S to deduct these expenses. This calculation must be reported separately on the return. The business entities must maintain specific accounting and inventory records. Businesses that only engage in either investment or rental activities would not usually report these amounts with their tax return.

How do I calculate the costs of goods sold for my taxpayer?

Use this simple formula to calculate the COGS:

COGS for the tax year = (Beginning Inventory + Purchases during the period) – Ending inventory

This calculation adds inventory amounts and purchased materials, including direct labor, together to find the subtotal cost. From this, subtract the ending inventory amount to get the total cost. To report the taxable income correctly, the taxpayer must calculate his or her inventories at the beginning and end of the tax year to determine an inventory value. This inventory value includes all completed good, raw materials, and supplies acquired for sale.