Hola! I hope you’ve read part one of my Inventory 101 series, which covers all the ins and outs of inventory. Click over here to see what should be included in inventory, how to properly track & record inventory, and whether you as a maker even need to deal with inventory as it is! Make sure to read that article before moving on to cost of goods sold, so you understand all the terminology.
I get what inventory is, now what exactly is cost of goods sold?
Remember how in my Inventory 101 post I discussed how you should treat the cost of your inventoriable supplies as an asset called “inventory”, rather than as an expense right away? Cost of goods sold (COGS) is basically what happens to your inventory when it sells. I like to think of this in terms of buckets…
You’re a maker. You buy a bunch of supplies and raw materials to make your goodies. Some of these supplies stay on your shelf (as I explained before, these supplies go into the inventory bucket). Some of these supplies go into some finished goods you make (these also go into the inventory bucket). All of these supplies and finished products are valued at cost, sitting in that inventory bucket. As soon as one of those finished goods sells, it (specifically, its cost) moves out of your inventory bucket, and into your COGS bucket.
Now this is how I like to think about cost of goods sold, in the form of an equation:
Beginning inventory is zero in your first year of business. For each year after that, beginning inventory simply equals last year’s ending inventory. Remember I said inventory is perpetual.
Materials and supplies are all those inventoriable supplies I’ve been harping on and on about. This is the total amount you spent this year for inventoriable supplies. Add that to your beginning inventory, that leads you to…
Inventory available for sale, which represents all the finished goods, works in progress, and unused raw materials and supplies sitting on your shelf. This is basically everything you’ve got in your shop that’s sitting around. If you take this amount and subtract out your…
Cost of goods sold, which we now know is the cost of all your finished goods that sell this year, then you are left with…
Ending inventory. This is the cost of all the finished goods, works in progress, and raw materials & supplies left on your shelf at year end that you did not sell. For taxes, you should always verify your ending inventory by doing a physical count of all your supplies & finished goods, and tabulating the cost of everything still sitting on your shelf at year end.
How do I keep track of cost of goods sold?
I personally believe that tracking COGS on a per product basis is the best way to handle a handmade biz. Why? Because it’s important to know how much your products cost you to make. If you know how much a product cost you to create, then you can price it more accurately. That means you can better ensure that your biz is actually covering costs and making a profit. For more about pricing for a profit, see my article here.
If you’re only calculating your COGS at year end and not tracking things as you go, then you don’t have this additional, super helpful data to make sure you’re pricing for profit.
If you enter your inventoriable supplies on a cost per unit basis (by recording both your purchase price and your total quantity purchased), then you’ve already got the data you need to keep track of your COGS. As you create a new item, you can simply add together the cost of all the supply units used in that good. The sum of these costs will get your “cost of goods made”, which I explained over in part 1. Keep a running log of the cost of goods made for everything you have for sale. When it sells, take that cost out of your inventory bucket, and add it into your COGS total for the year. Easy peasy. You should still verify this COGS total with a physical count before you do your tax return!
If this still sounds overwhelming to you, check out our Inventory Cost & Pricing spreadsheet. This spreadsheet is already set up to help you through all the steps I just outlined. It will guide you through calculating your cost of goods made for everything you make on a per item basis, and then as you sell it, it automatically moves it to your COGS total bucket.
So, how do I deal with inventory and cost of goods sold on my tax return?
At the end of the tax year, you’ll be required to report your total “ending inventory” bucket on your tax return. Basically, all the tax man cares about are your year-end totals for inventory and COGS. In order to calculate these amounts, you’ll also need to know your total inventoriable supply purchases for the year.
It’s worth noting that as far as your tax return goes, COGS is simply a calculation you back into. That means that technically, for tax purposes, you do NOT need to keep track of COGS throughout the year…but as I argued earlier, I totally think you should to help you effectively price your goods and keep track of your taxable net profit or loss for the year.
The inventory section of your tax return is going to look something like this:
Here’s my interpretation of this in plain English for you:
There are a few extra lines here, but this is pretty much the same equation that I explained earlier, just with some components switched around. Basically, instead of solving for “ending inventory”, your tax return asks you to solve for “cost of goods sold”. In the first case, ending inventory is your calculated amount. In the second case (on your tax return), COGS is your calculated amount.
So just know and understand that for tax purposes, COGS is a calculation. If you’re tracking your inventory and COGS as you go, you should already have a good idea of your ending inventory for Schedule C. You will just need to confirm this number with a physical count at year end (you may need to adjust for waste, scraps, trash, loss, etc.). You’d also already have a good idea of what your COGS total should be at year end.
The amount you calculate on Line 42, your COGS, travels to page 1 of your Schedule C, on Line 4. Your COGS then gets deducted against your business’ profit, and lowers your tax bill. This is why it’s essential to correctly track and calculate COGS, because it’s a very important, and potentially beneficial, deduction for you.
Wait, what about those “supplies used for personal use”?
The government does not want you to get a cost of goods sold deduction for any supplies you may have originally bought for your biz and then ended up using for personal use. That means if you make baby clothes and end up making clothes for your neighbor’s new baby, you don’t get a business deduction for the cost of those clothes. You have to take them out of your inventory and COGS calculation.
What about cost of labor?
Unless you pay people to help create the stuff you sell, your cost of labor is blank. You do NOT include what you “pay” yourself here.
Where can I find out more about Schedule C and taxes?
Hold on, I heard from my accountant/crafty friend/mom’s uncle’s brother-in-law who does taxes that I don’t have to deal with inventory since I’m just a small biz.
Inventory, like many tax topics, can be a controversial topic amongst small biz owners. I am a CPA and I still get confused by how to interpret IRS tax rules & regs.
On one hand, I have heard of many other small biz owners, crafters, and Etsy-preneurs who have chosen not to keep track of inventory. Or, they simply don’t even know to do such a thing and claim ignorance. I have even heard of accountants who advise biz owners that they do not need to worry about inventory or cost of goods sold, based on their interpretation of the tax rules. On the other hand, I also know many accountants and tax preparers who strongly believe that the IRS does require us to keep track of our inventory. You’d think something so time-consuming would be a little more black and white, right?
Since it’s not the purpose or intent of this blog to give you tax advice, I simply must encourage you to delve into this issue on your own. Talk to your accountant or tax preparer (get one if you don’t have one). Ask them direct and specific questions about inventory. Make sure you’re talking to someone who is very familiar with not just small businesses, but crafty ones who make things. Read the rules yourself. Do the research.
I will tell you that as a biz owner I do believe that you are indeed required to keep track of your inventory and fill this out on your tax return. I do believe that if the IRS audits you, you will be on the hook for this. All IRS guidance tells us that you must handle inventory in a way that clearly reflects your income. Deducting all those unsold supplies in the year of purchase does not clearly reflect your income. It can greatly inflate a loss or drastically reduce your actual net income.
I totally admit – keeping track of your inventory and COGS can be quite time-consuming depending on how your biz works. That’s why I saw the need to create our Inventory Cost & Pricing spreadsheet, which I encourage you to check out. The decision is ultimately up to you and you alone. But besides being tax compliant, keeping track of your inventory gives you the huge advantage of understanding your costs for price-setting purposes to make sure you’re actually running a profitable business.
Wanna learn about this topic in a video format? I cover inventory in-depth in my course, the Get Legit Toolkit, which you can learn all about at the end of this free tax training. In the Get Legit Toolkit, we dive into ALL the in’s and out’s of inventory, and I answer tons of questions about how to deal with tough items like fabric, vinyl, paint, thread, and more. We also discuss the best ways to get caught up on inventory if you’re behind. Plus the course covers many other useful topics for getting your financial ducks in a row!
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