How Is the Cost of Goods Sold Tax Deduction Calculated?

Businesses that sell products must track costs carefully, as these expenses impact profitability and tax obligations. A key deduction available is the cost of goods sold (COGS), which reduces taxable income by accounting for direct costs related to producing or purchasing inventory.

Understanding how this deduction is calculated ensures compliance with tax laws while maximizing savings.

Qualifying Costs

COGS includes expenses directly tied to producing or acquiring inventory, typically categorized as materials, labor, and overhead.

Materials encompass raw goods used in manufacturing or wholesale purchases for resale. A furniture maker’s wood, nails, and fabric qualify, as do a retailer’s inventory purchases.

Labor costs must be directly related to production. Wages for factory workers assembling products or bakers preparing goods for sale are included, while administrative and sales staff salaries do not qualify. Payroll taxes and benefits for production employees can also be factored in.

Overhead covers indirect costs necessary for production, such as factory rent, utilities, and equipment depreciation. The IRS allows businesses to allocate a portion of these costs to COGS if they are directly linked to manufacturing or inventory storage. For example, rent and utilities for a warehouse used solely for storing inventory can be included.

Inventory Valuation Methods

Determining inventory value is essential for calculating COGS, as it affects taxable income. Businesses must choose a valuation method that aligns with their financial strategy and complies with IRS regulations.

First-In, First-Out (FIFO) assumes the oldest inventory is sold first. When costs rise, this results in lower COGS and higher taxable income. For example, if 100 units are purchased at $10 each and another 100 at $12, selling 100 units under FIFO records COGS at $10 per unit, leaving the higher-cost inventory on the balance sheet.

Last-In, First-Out (LIFO) assumes the most recent inventory is sold first. This can lead to higher COGS and lower taxable income when prices increase. However, businesses using LIFO for tax purposes must also apply it in financial reporting under the conformity rule. LIFO is prohibited under International Financial Reporting Standards (IFRS), which may be a limitation for global companies.

The Weighted Average Cost method calculates inventory value based on the average cost of all units available for sale. This approach smooths price fluctuations and provides consistency in financial reporting. If 200 units—100 at $10 and 100 at $12—are purchased, the average cost per unit is $11. If 50 units are sold, COGS is recorded at $11 per unit.

Calculating the Deduction

Accurately determining COGS requires businesses to account for beginning and ending inventory, along with direct costs incurred during the year. The IRS mandates the following formula:

Beginning Inventory + Purchases and Production Costs – Ending Inventory = COGS

The process starts with the inventory value at the beginning of the tax year, which should match the prior year’s ending inventory. Any discrepancies could trigger an audit or require adjustments to prior filings.

Throughout the year, businesses must track inventory purchases and production-related expenditures, including factory supplies and packaging materials.

At year-end, remaining inventory is valued based on the chosen inventory valuation method. Overstating ending inventory results in a lower COGS deduction, increasing taxable income, while understating it can lead to compliance issues. The final calculation determines the deductible amount that offsets gross revenue and impacts tax liability.

Recordkeeping Essentials

Maintaining accurate records is necessary for businesses claiming the COGS deduction. The IRS requires documentation to substantiate deductions, and incomplete records can lead to audits, penalties, or denied claims. Businesses must track inventory movements, purchase invoices, and production costs.

A structured recordkeeping system should capture transaction details in real time, reducing errors and missing data. This includes purchase orders, supplier invoices, and receipts for inventory-related expenses. Digital accounting software, such as QuickBooks or Xero, can automate data entry and generate audit-ready reports. Businesses using perpetual inventory systems must ensure records align with physical inventory counts to prevent discrepancies that could raise red flags during an IRS examination.

Tax law requires businesses to retain records for a specific duration. The IRS typically mandates keeping inventory-related documentation for at least three years from the tax return filing date. However, if fraud or substantial errors are suspected, audits can extend up to six years. Secure storage solutions, such as cloud-based backups, help safeguard financial data.

Adjusting for Inventory Changes

Fluctuations in inventory levels impact the COGS deduction, requiring businesses to account for losses, write-downs, or valuation adjustments.

Inventory shrinkage—due to theft, damage, or obsolescence—reduces the value of goods available for sale. Businesses must document these losses through physical inventory counts and adjust financial records accordingly. The IRS permits deductions for inventory shrinkage if substantiated with records such as loss reports or insurance claims. If inventory becomes obsolete or unsellable, companies may write down its value under lower of cost or market (LCM) accounting rules, reducing taxable income.

Changes in inventory accounting methods require careful consideration. Switching from FIFO to LIFO, or vice versa, mandates filing Form 3115 (Application for Change in Accounting Method) with the IRS. These changes can significantly impact tax liability, as they alter the timing and amount of COGS deductions. Businesses should evaluate whether a method change aligns with their financial strategy, especially in industries with fluctuating inventory costs.