Is Rent Included in Cost of Goods Sold?
Discover whether rent factors into Cost of Goods Sold. This guide explains how to properly classify your business's rent expenses.
Businesses often face a common question regarding the classification of rent in their financial records: Is rent included in the Cost of Goods Sold (COGS)? Understanding the nuances of how rent is categorized is essential for accurate financial reporting and tax compliance. The distinction largely depends on the purpose of the rented asset within the business operations.
Defining Cost of Goods Sold
Cost of Goods Sold (COGS) represents the direct costs a business incurs in producing the goods it sells. For businesses that manufacture or purchase goods for resale, COGS is a significant figure on the income statement, directly impacting gross profit. The Internal Revenue Service (IRS) considers COGS to include costs of materials used, direct labor, and a share of overhead expenses.
The primary components of COGS are direct materials, direct labor, and manufacturing overhead. Direct materials are raw elements that become part of the finished product. Direct labor includes wages of workers directly involved in the production process. Manufacturing overhead encompasses all indirect costs related to production that are necessary for their creation.
Understanding Rent
Rent is an expense paid for the use of property, equipment, or other assets not owned by the business. Businesses might rent various assets, including buildings for operations, machinery for production, or vehicles for transport.
Rent payments represent a fixed operating cost for a business. The way these rental payments are categorized significantly influences a company’s financial statements and tax obligations. Rent is generally recorded as an expense on the income statement.
Rent Included in Cost of Goods Sold
Rent is included in the Cost of Goods Sold when the rented asset is directly or indirectly involved in the production or manufacturing process. Such rent is classified as part of manufacturing overhead, a component of COGS.
For example, rent paid for a factory or production plant where goods are manufactured is part of manufacturing overhead. Rent for machinery or equipment directly used in the manufacturing process, such as assembly line equipment, also falls into this category. The IRS uniform capitalization rules (Code section 263A) require certain indirect costs, including rent, to be capitalized as part of inventory costs if they relate to production or resale activities.
Rent for a warehouse used for storing raw materials or finished goods before they are sold is also included as manufacturing overhead. This is because storage is a necessary step in the production and sales cycle, making the associated rent an indirect cost of production.
Rent Not Included in Cost of Goods Sold
Rent is not included in the Cost of Goods Sold when it relates to activities not directly involved in the production of goods. These types of rent are classified as operating expenses, specifically under Selling, General, and Administrative (SG&A) expenses. These expenses are necessary for overall business operation but do not contribute to the direct cost of creating the product itself.
Examples include rent for administrative offices, such as a company’s headquarters or human resources departments. Rent for retail storefronts or showrooms, where goods are sold but not produced, is also an operating expense. Similarly, rent for sales offices or marketing departments is categorized as an operating expense because these functions support sales rather than production.
Rent for warehouses used for distribution after goods have been produced and are ready for sale is also excluded from COGS. While important for getting products to customers, this type of rent is a post-production expense.