Should Sales Tax Be Included in Cost of Goods Sold?

Understanding how sales tax interacts with the Cost of Goods Sold (COGS) is important for accurate financial reporting and effective business management. The treatment of sales tax depends on whether the business is collecting it from customers or paying it on its own purchases.

Defining Cost of Goods Sold

Cost of Goods Sold (COGS) represents the direct costs incurred in producing the goods a company sells. These costs are directly tied to the creation or acquisition of products intended for sale. Common components include direct materials, direct labor, and manufacturing overhead. COGS does not include indirect expenses such as marketing, sales force costs, or general administrative expenses. This financial metric is subtracted from revenue to determine a company’s gross profit, providing insight into the profitability of its core operations.

Understanding Sales Tax

Sales tax is a consumption tax imposed by state and local governments on the sale of various goods and services. Businesses collect this tax from customers at the point of sale, acting as an agent for the taxing authority. The collected amounts are then remitted to the appropriate government entity. Sales tax is commonly referred to as a “pass-through” tax, as the business facilitates its collection and transfer. Sales tax rates vary significantly by state, county, and city, and are calculated as a percentage of the selling price.

Sales Tax Collected from Customers

Sales tax collected by a business from its customers is generally not included in the Cost of Goods Sold. This is because these amounts are not an expense of the business itself. Instead, the business acts as a temporary custodian of these funds on behalf of the government. The collected sales tax is recorded as a current liability on the company’s balance sheet, typically in an account called “Sales Tax Payable.”

This liability reflects the business’s obligation to remit the collected funds to the taxing authority. On the income statement, sales tax collected does not flow through as revenue, nor is it an expense. The revenue recorded from a sale should be the price of the good or service before sales tax is added. When the business remits the sales tax to the government, the Sales Tax Payable liability account is reduced, and cash is decreased.

Sales Tax Paid on Business Purchases

When a business pays sales tax on its own purchases, the accounting treatment can differ depending on the nature of the purchased item. If the business is the end consumer of items like office supplies, the sales tax paid is typically considered part of the overall expense of that purchase. This means the sales tax is expensed along with the cost of the item itself. For example, if a business buys $100 worth of cleaning supplies with an 8% sales tax, the total $108 is recorded as an expense.

However, if sales tax is paid on items intended for resale or direct use in the production of goods, it can be capitalized into the cost of that inventory. For instance, if a manufacturer purchases raw materials and pays sales tax, that sales tax can be added to the cost basis of the raw materials. This increased inventory cost then flows into Cost of Goods Sold when the finished product is sold.

Similarly, sales tax paid on the acquisition of a fixed asset, such as machinery or equipment, can be included in the asset’s capitalized cost. This means the sales tax becomes part of the asset’s total cost and is then expensed gradually over the asset’s useful life through depreciation. Therefore, sales tax paid by the business on its own purchases can either be expensed immediately or capitalized into the cost of inventory or assets, impacting COGS or depreciation over time.