 Income tax 2022-2023. How to figure cost of goods sold? Let's do some wealth preservation with some tax preparation. Most of this information can be found at the tax guide for small business for individuals who use schedule C publication 3-3-4 tax year 2022. You can find on the IRS website irs.gov irs.gov. Looking at the income tax formula we're focused online one income remember in the first half of the income tax formula is in essence an income statement however it's just an outline just a scaffolding other forms and schedules flowing into it the schedule C being one of them the schedule C for business income in essence an income statement in and of itself support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category further broken out by course each course then organized in a logical reasonable fashion making it much more easy to find what you need then can be done on a YouTube page we also include added resources such as Excel practice problems PDF files and more like QuickBooks backup files when applicable so once again click the link below for a free month membership to our website and all the content on it business income minus business expenses the net then rolling in from schedule C to line one income of the income formula here this is page one of the form 1040 the schedule C would flow into the schedule 1 flowing into line 8 of the form 1040 as we see the schedule C is up top profit or loss from business we can see it's an income statement in essence income and expense categories so now we want to talk about figuring cost of goods sold on schedule C lines and so the cost of goods sold note would only be something that would be relevant if you're dealing with inventory so as a general rule if your service business you won't have inventory not typically gonna have to deal with cost of good sold cost of goods sold is gonna be the expense related to the consumption of inventory in order to generate revenue so remember that in essence the expenses what expenses are are things that we're consuming under the matching principle we would like to match them up in the same period that they were consumed in order to generate the revenue if you sell inventory and that's your primary form of revenue generation the cost of goods sold is typically going to be the biggest and most important expense and therefore a lot of focus will be on the cost of goods sold and we'll have another kind of sub-total calculation generally which will be gross profit income minus the cost of goods sold gives us the gross profit so from an accounting standpoint you can think about different methods you might use to basically track the inventory and record the cost of goods sold but whatever method you use if you're putting the inventory on the books as an asset you are basically doing an accrual type of thing then you might track the inventory using a periodic system or a perpetual system a periodic system would be one in which you you record the purchases and then periodically you count the inventory at the end of the day week or month and you make an adjustment to record the decrease in the inventory and the related cost of goods sold a perpetual inventory system would be one in which you're recording the decrease in the inventory every time you make a sale because you have more usually need more sophisticated accounting software that's going to be making that transaction recording that transaction with every sale you might be using flow assumptions like a first in first out last in first out weighted average kind of flow assumptions for the inventory for the income taxes we're going to have a schedule a schedule C and then the cost of goods sold schedule you'll have to deal with which is in essence a cost of goods sold calculation that you might be familiar with using like a periodic inventory type of system which is in essence beginning inventory which should match the ending inventory on the prior year tax return if you had the business in the prior year plus purchases minus ending inventory gives us the bottom line the cost of goods sold okay so if we're going to figure the cost of goods sold figure your cost of goods sold by fire by filling outlines 35 through 42 of schedule C these lines are reproduced below and are explained in the discussion that follows so we've got line 35 inventory at the beginning of the year if different from last year's closing inventory attach explanation in other words this line should be the same as last year's basically ending inventory which would be here on the prior year return because obviously the end of last year is going to be the same as as this year now oftentimes when you're trying to account for things from period to period this is this beginning balance rollovers are one of the one of the areas where people have issues with so so you might have to go back and kind of figure out why there's a difference between beginning inventory in some cases but then you've got the purchase purchases less cost of items withdrawn for personal use cost of labor do not including any amounts paid to yourself materials and other supplies other costs and then you're adding them up notice that if you're just buying and selling inventory then you're a merchandising company out more and the inventory is a little bit easier because you're just going to have purchases just purchases of what you bought the inventory then you sold it but if you are making inventory you might be using a process cost system or job cost system then you've got to deal with the materials and the supplies and the work in process and all that kind of stuff within your inventory and that gets a little bit more complicated but the general formula beginning inventory plus the purchases or what was produced right and then that gives you your inventory at the end of the year ending inventory and then you're going to subtract these two out that's what you sold cost a good sold so in other words beginning inventory plus what you purchased gives you the amount of inventory that could have been sold throughout the year the available inventory that was there to sell and then if we count the inventory at the end of the year the stuff that has not yet been sold the difference between what could have been sold and what has not been sold would would be the cost of good sold the expense related to the things that we sold which would be part of the income statement as one of the major expense for a company that deals with inventory so note that sometimes if you're using your own bookkeeping system this number is going to be something that should be known because you got it from the prior your tax return and then your your inventory at the end of the year should be known because that'll be in the accounting software and then your cost to get sold might be known if you're using accounting software and you already have an income statement which means you could use algebra to ancient Egyptian algebra get to the unknown which would be the purchases right and then it gets a little bit more difficult sometimes if you have a construction or job cost type of system or process cost type of system a manufacturing company instead of just buying and selling inventory okay that said let's dive into some of these lines in more detail line 35 inventory at beginning of the year so if you are a merchant beginning inventory is the cost of merchandise on hand at the beginning of the year that you will sell to customers so if you are a manufacturer or producer it includes the total cost of raw materials working processed finished goods those are the three buckets by the way when you're producing inventory you're buying inventory it's raw material then you're producing the or you're working on it then it's working process when you're done working on it ready to sell it it's finished good inventory so and materials and supplies used in manufacturing the goods so you can see inventories in chapter two for more detail on that so opening inventory will usually be identical to the closing inventory of the year before you want to make sure to double check that because that's something if it's not that way and you don't tell the the iris why it's different that you might the iris might question that that could be a red flag as they say so you must explain any difference in the schedule attached to your return donation of inventory if you contribute inventory property that you sell in the course of your business the amount you can claim as a contribution deducting is the smaller of its fair market value on the day you contributed it or its basis so notice if you're you know giving inventory contributing inventory then you've got this valuation type of problem situation in terms what's the value of the inventory because you bought it for a certain price and then you're gonna sell it for you know the retail price or whatever so the basis of donated inventory is any cost incurred for the inventory in an earlier year that you would otherwise include in your opening inventory for the year of the contribution you must remove the amount of your contribution deduction from your opening inventory it is not part of the cost to good soul if the cost of donated inventory is not included in your opening inventory the inventories basis is zero zero zero zero zero and you cannot claim a charitable contribution deduction treat the inventories cost as you would ordinarily treat it under your method of accounting for example include the purchase price of inventory bought and donated in the same year in the cost of good sold for that year a special rule may apply to certain donations of food inventory see publication five to six charitable contributions for more for more information there example one you are a calendar year taxpayer who uses an accrual method of accounting in two thousand twenty two you contributed property from inventory to a church so you go you got a church you're gonna give something to them you're gonna give them not cash but the inventory it had a fair market value of six hundred dollars the closing inventory at the end of two thousand twenty one property included four hundred dollars of cost due to the acquisition of the property and in two thousand twenty one you properly deducted fifty dollars of administration and other expenses attributable to the property as business expenses the charitable contribution allowed for two thousand twenty two is four hundred which is the six hundred dollars minus the two hundred dollars the two hundred is the amount that would be ordinary income if you had sold the contributed inventory at fair market value on the date of the gift the cost of goods sold you used to determining gross income for two thousand twenty two but must not include the four hundred dollars you remove that amount from opening inventory for two thousand twenty two that's kind of an unusual situation where we have this charitable contribution but it gets a little bit messy in those cases so example two if in example one you acquire the contributed property in two thousand twenty two at a cost of four hundred dollars you would increase the four hundred dollar cost of the property in figuring the cost of goods sold for two thousand twenty two and deduct the fifty dollars of administration and other expenses attributable to the property for that year so you would not be allowed a charitable contribution deduction for the contributed property all right let's go to line thirty six purchase less cost of items withdrawn for personal use so now we're taking taking stuff out for personal use so if you are a merchant use the cost of merchandise you bought for sale if you are a manufacturer or producer this includes the cost of all raw materials or parts purchased for manufacture into a finished product so again purchase less cost of items withdrawn for personal use so in other words if you're just buying inventory and selling it then it's fairly straightforward because you're going to put it on the on the cost that you purchased it for if you have inventory that you're constructing into end use then because it's a manufacturing company gets a little bit more complicated so once again if you are a merchant just buying and and marking up and then selling inventory use the cost of all merchandise you bought for sale if you are a manufacturer meaning you're converting the inventory from raw materials to finish good or producer this includes the cost of all raw materials or parts purchased for manufacture into a finished product so trade discount the differences between the stated prices of articles and the actual prices you pay for them are called trade discounts you must use the prices you pay not stated prices in figuring your cost of purchase in other words you're purchasing these items of inventory they had a stated price the sticker price but you actually bought them for something other than the sticker price possibly less than a sticker price obviously you want to record them from an accounting standpoint at the price that you actually paid for them not the sticker price because that's different so do not show the discount amounts separately as an item in gross income so an automobile dealer must record the cost of a car in inventory reduced by any manufacturer's rebate that represents a trade discount for example so cash discounts cash discounts or amounts are your suppliers let you deduct from your purchase invoices for prompt payment so these are a form of discounts that are usually a lot lower in in amount because they're just trying to incentivize you to pay them earlier than you otherwise would as you do your time value of money the general concept for time value of money from the payable side is i'm going to pay as late as possible without until i don't get penalized and from the recipient side they want to get their money as soon as possible so if the recipient wants their money sooner than the terms of the agreement they could try to give a small discount to incentivize that to to take place so there are two methods of accounting for cash discounts you can either credit them to a separate discount account or deduct them from total purchases for the year so we saw this in a prior presentation if you're buying inventory for example you you you could say well i know i'm going to take on the discount so even though i'm purchasing it on account i'm going to assume i pay it within 10 days instead of 30 days for example because they're going to give me a 10 a discount within 10 days and i'm going to mark it in at that price or you could say i'm going to just use the normal price not including the discount that i'm going to purchase it for and then when i do get that small cash discount then what am i going to deal with it i might have to record it basically i'm i can revalue the inventory after adjusting for the discount that they gave me because i've recorded it at the higher price not including the discount assuming that i'm going to pay them in 30 days instead of 10 days but now i paid them in 10 days and i got the discount so am i going to adjust the value of the inventory at that point in time or because it's a fairly small discount just record it possibly as uh income or something at the point in time they give me the discount which other method you use you must be consistent if you want to change your method uh of figuring inventory cost you must file form 3 1 1 5 for more information you could see change in accounting method in chapter 2 so if you credit cash discounts to a separate account you must include this credit balance in your business income at the end of the tax year if you use this method do not reduce your cost of goods sold by the cash discount so then we got the purchase returns and allowances you must deduct all returns and allowances from your total purchases during the year now this gets a little bit confusing because when we talk about returns and allowances you can think about am i talking about the returns that are coming from the customers that i sold the inventory to that are returning no here we're talking about the inventory that you rejected that you bought from your vendors and you're returning it to them and therefore you must deduct all returns and allowances from your total purchasing during the year because you returned them so merchandise withdrawal from sale so if you withdraw merchandise for your personal or family use so now you're going to take the you're going to take dip it into your own stash of the merchandise so you must exclude this cost from the total amount of merchandise you bought for sale do this by crediting the purchases or sales account with the cost of merchandise you withdraw for personal use you must also charge the amount to your drawing account you're basically taking out a draw because you're you're consuming the the merchandise for personal use so so that would be like similar to to pulling money out of the business after generated money but instead of pulling the money out you're drawing out the merchandise so a drawing account is a separate account you should keep to record the business income you withdraw to pay for personal and family expenses so in other words when you take money out you can't record it as a business expense lowering net income but instead as a draw which is a balance sheet account which isn't shown on the tax return because the tax return only has an income statement generally so so when you're doing your accounting it would be a balance sheet account that would be not recording an expense on the income statement for a draw because you took it out for personal use you didn't expend the money or the expense for the business so as stated above you also use it to record withdrawals of merchandise for personal or family use this account is also known as a withdrawal account or personal account line 37 cost of labor labor costs are usually an element of cost of goods sold only in a manufacturer or mining business so if you're just buying and selling merchandise then you're not going to have labor it's going to be specific to an industry small merchandisers wholesalers retailers etc usually do not have labor costs that can properly be charged to cost to goods sold in other words you might have employees and whatnot but they're not actually making the inventory if you're in like a service business so those would be just wages expense not part of cost to goods sold so in a manufacturing business labor costs properly allocated to the cost of goods sold include both the direct and indirect labor used in fabricating the raw material into finished sellable products so when you're in a manufacturing company you've got workers that are working on the actual products those that you can draw specifically to a specific product are more like the direct laborers indirect laborers are doing something like in the warehouse where they're making the products but it's still kind of going towards the construction of the product and therefore you wouldn't just expense it as a expense but rather include it as part of the cost to goods sold the inventory that you're going to sell in expensing it in the form of cost to goods sold at the point in time the inventory is sold direct labor direct labor costs are the wages you pay to those employees who spend all their time working directly on the product being manufactured they also include a part of the wages you pay to employees who work directly on the product part time if you can determine that part of their wages indirect labor indirect labor costs are the wages you pay to employees who perform a general factory function like they do something within the factory the maintenance of the factory itself so you can't you can't allocate it to a specific unit of inventory but their cost is helping the manufacturer of inventory in general that means that you have to use some method to allocate their indirect to the to the units which becomes an accounting issue but anyways immediate or direct connection with making the sellable product but that is a necessary part of the manufacturing process so other labor other labor costs are the properly chargeable to the cost of goods sold can be deducted as a selling or administration expenses so if they're not included in the cost of goods sold they're just like a normal kind of expense which would be selling an admin expense not part of the cost of goods sold generally the only kinds of labor costs properly chargeable to your cost of goods sold are the direct or indirect labor costs and certain other costs treated as overhead expenses properly charged to the manufacturing process as discussed later line 39 other costs all right so we'll get to there soon line 38 materials and supplies materials and supplies such as hardware and chemicals used in manufacturing goods are charged to the cost of goods sold those that are not used in the manufacturing process are treated as deferred charges you deduct them as a business expense when you use them business expenses are discussed in chapter 8 and you got line 39 other costs example of other costs include in a manufacturing or mining process that you charge to your cost of goods sold are as follows you got the contractors so contractors impact we've got the containers i'm sorry containers not contractors containers and packages that are an integral part of the product manufactured are a part of your cost of goods sold so now you're manufacturing something and you've got to put them into the container so that container then is going to be part of basically your inventory your cost of goods sold so if they are not an intangible part of the manufactured product the costs are shipped or selling expenses so freight in freight in express in and cartage in on raw materials supplies you use in production and merchandise you purchase for sale are all part of the cost of goods sold so note that's a little bit confusing because that doesn't include other kind of shipping costs that aren't related to the cost of goods sold which might be an expense right it's only they're going to be the stuff that's shipping that's part of the manufacturing process you needed that in order to help you to do the the inventory overhead expenses overhead expenses included expenses such as rent heat light power insurance depreciation taxes maintenance labor and supervision you can usually think if there's a like a manufacturing process anything that's in the warehouse imagining the warehouse being different than the administrative office and the stores or the sales areas if it's part of the manufacturing process all the labor in there the lights the power the insurance the depreciation on the equipment is all part of making the inventory and therefore you would think it wouldn't be expensed just as a normal operating expense but rather be in essence capitalized or included as part of the cost of goods sold and expensed as cost of goods sold part of the inventory when sold so the overhead expenses you have as direct and necessary expenses of the manufacturing operation are included in your cost of goods sold line 40 add lines 35 through 39 the total of line 35 through 39 equals the cost of the goods available for sale during the year so if you were a non-manufacturing company it would be quite easy you would just be saying per your beginning inventory plus what you bought throughout the whole year not including what you sold or the decreases that would give you the amount available for sale the amount that you could have sold during the year if you made the inventory you've got the beginning inventory plus all the stuff the raw materials and whatnot that you put in place in order to get to the end value which is the ending inventory that's including the raw materials work and process finished goods and so on okay and then we've got line 41 inventory at the end of the year subtract the value of your closing inventory including as appropriate the applicable parts of the cost of raw materials and supplies direct labor and overhead expenses from line 40 so now you're going to say i'm going to look at my ending inventory what i have left that is still on hand at the end of the year so inventory at the end of the year is also known as closing or ending inventory your ending inventory will usually become the beginning inventory for next year so you can think about that you can imagine it as a physical count of inventory however we're not going to have to we can't just put it on the books as a number of units of inventory but rather as a dollar value reflecting the number of units of inventory and that should be the same for the ending inventory here as the beginning of the next year line 42 cost of goods sold when you subtract your closing inventory inventory at the end of the year from the cost of goods available for sale the remainder is your cost of good sold during the year so if you think about just someone that buys inventory marks it up and sells it the calculation would be you've got your beginning inventory that's what was there you can imagine physical inventory for the beginning of the year plus the amount that you purchased throughout the whole year not you're trying to say yeah but i sold during the year too but now we're talking about the whole year in whole so we're going to say the purchases that you made throughout the entire year that added together gives you the amount available for sale the amount that you could have sold during the year it doesn't mean you had that amount on hand at any one time during the year it means that if we imagine everything that you had at the beginning plus what you purchased that's what you had and could have sold during the year if we take what you could have sold minus the ending inventory the stuff that's still on hand that you didn't sell then that difference should be the cost of good sold now you might think that there's shrinkage or spoilage and whatnot that comes into play but again that's the concept of it that's the concept of the calculation beginning inventory plus purchases gives you the amount available for sale minus what you still have that you didn't sell means that's the cost of good sold the expense that we want to see on the in the on the income statement of of the inventory that was consumed that we want to match to the same period that it was consumed to generate the related