Inventory and cost of goods sold are probably the most complex accounting concepts that makers and crafters have to tackle. Today I’m going to attempt an overview of some important inventory concepts in simple, plain English. In part 2, I’ll delve into dealing with cost of goods sold (COGS).
Whether or not to keep detailed inventory counts & records can be a somewhat controversial topic in the maker community. There’s a lot of debate out there about whether the IRS requires small biz makers & crafters to track inventory and COGS or not.

Before I dive in, understand that accurately recording your inventory and supply costs is important for both taxes and bookkeeping purposes. It can save you a big headache in case of an audit, but it can also help you accurately price your goods and ensure profitability for your shop.
Does inventory even apply to me?
If you sell physical goods, then you likely have to deal with inventory. This true whether you’re crafting items from supplies (like a jewelry maker), making goods to order, buying finished goods at wholesale and simply reselling them, sourcing vintage goods and selling them at a markup, or anything in between.
You do not have to deal with inventory if you’re strictly a service provider, or if you sell only digital goods (lucky, lucky you!).
What is considered inventory?
For tax purposes, all of the following are considered to be inventory:
Finished goods –
In general, your inventory includes the finished products you have for sale on your shelf.
What does that mean? If you’re a maker or a crafter, and you make items and then list them for sale or bring them to a craft show, all those items you have up for sale are considered your inventory. They’re really considered inventory whether you’ve already got them listed for sale, or whether they’re in a pile waiting to be stocked. If it’s a finished item ready to go, then it’s part of your inventory.
Works in progress –
If there’s stuff you’re working on that’s not “finished” but a work-in-progress, that’s considered part of your inventory too.
Inventoriable raw materials & supplies –
To make matters more complex, some of your materials and supplies are considered part of your inventory as well. We’ll discuss that in the next question.
The important thing to note here is that for tax purposes at least, inventory is not just your finished goods. Inventory has to include your giant supply stash as well. Please note that “inventoriable supplies” is a term that I’ve made up myself, just to easily distinguish supplies that are supposed to be part of inventory vs. supplies that don’t have to be part of your inventory, which leads me to…
What raw materials & supplies are considered “inventoriable”?
Your materials & supplies probably make up the biggest spending category for your handmade biz. So, it’s really important to know – what materials & supplies are considered “inventoriable” and need to be part of your inventory?
Any raw materials or supplies that go directly into your finished goods are considered inventoriable for tax purposes. So if you make purses, your inventoriable supplies would include fabric, zippers, or buckles. If you make jewelry, your inventoriable supplies would include beads and earring studs. If you create felt banners, your inventoriable supplies would include felt and twine. Basically all those supplies that you hoard from Hobby Lobby fall into the inventory bucket, as long as you’re using them in the goodies you sell.

What raw materials & supplies are NOT part of inventory?
Materials & supplies that are purchased for general business use that do not go directly into the items you sell are not part of inventory. These are things like office supplies (printer ink and printer paper), tools (scissors, pliers, or paint brushes), packaging supplies, etc. You may use your tools to make your goods, but they are not part of your goods, thus they don’t have to be included in inventory.
Materials & supplies that are considered “incidental” are also not part of your inventory, even if they go into your finished goods. Incidental materials are supplies that are difficult to measure or trace, or they are just a tiny unimportant piece of your good. Examples are supplies like thread or glue. You might use these in the products you sell, but knowing exactly how much thread you have on hand would be pretty darn hard to measure, plus the cost of the incidental supply used throughout the year is probably pretty minimal.
Note that, for tax purposes, all of these non-inventoriable supplies can be expensed (or deducted) in the year you purchase them. This is an important distinction that I will explain in detail later. Just remember – non-inventoriable supplies can be deducted in the year of purchase. Inventoriable supplies can only be deducted (as part of COGS) in the year you sell the item made with that supply.
When determining whether a supply is incidental or not, keep in mind that our goal is always to give an accurate and clear picture of our business’ net income. If you have paint as a supply, that is indeed something that’s hard to trace or measure. But if paint is a big piece of what you sell (like painted wooden signs for example), and you spend quite a bit on paint and have a lot of paint sitting around at any point in time, chances are your paint is not an incidental expense or supply and you should be inventorying it.
Ok, so how do I record and track my inventoriable supplies?
As you purchase inventoriable raw materials and supplies, you should have a system of entering the necessary information for each item. {I highly recommend a Paper + Spark inventory spreadsheet for keeping track of these items. This spreadsheet does a lot of the math work for you, and helps you keep track of supplies, inventory totals, and COGS on an on-going basis.}
You will need to record the cost of each supply item and the quantity purchased. When I say the cost of the item – I mean the actual amount you paid, including any discounts, coupons, sales taxes, or shipping. (If you’re wondering how to divide shipping cost amongst multiple supply items purchased at once, check out my shipping guide here.)
When I say quantity purchased – I mean in whatever unit of measurement that makes the most sense to you. That could be an actual count, square inches, square feet, weight in ounces, etc. Chose a unit of measurement for each type of supply and be consistent with each purchase.
You should then determine your newly purchased supply’s cost per unit. Cost per unit is simply the cost of your supplies divided by the quantity purchased. You can do this manually on a calculator, or use a system that will take your two inputs and automatically calculate the cost per unit for you, like our Inventory for Handmade Sellers spreadsheet.

Why does cost per unit matter?
In order for you to know how much a finished good cost you to create, you need to know the cost per unit of all your supplies. So now when you make a new pair of earrings, you can say these earrings used X number of beads, and each bead cost me $X, and each earring hook cost me $Y. So now I’m able to calculate exactly how much this pair of earrings cost me to create in terms of supplies.
Knowing exactly how much in supplies goes into a finished product is not just important for tax purposes, it helps with pricing too. Read more about pricing accurately based on your costs here.
How do I value my inventory?
Inventory should be valued at cost, not at retail. That means for finished goods, you need to know how much that good cost you to create in terms of inventoriable supplies (which you can easily calculate if you’re keeping track of the cost per unit!). This way you can easily calculate the cost of every little bit that went into creating your item.
You are welcome to keep track of the retail value of the inventory you have on hand, but you do not need to know this for tax purposes (you might need to know it for insurance or bookkeeping purposes, though).
What is “cost of goods made”?
I like to call the total cost of all my finished goods the cost of goods made. It’s just another way of looking at the cost of all the finished goods waiting to be sold on your shelf. Once an item sells, it’s “cost of goods made” magically turns into it’s cost of goods sold (cause it sold, get it?).

Do I have even have inventory?
If you create items to order, like someone who makes custom baby clothes, you probably still have inventory. This is because you still have supplies on hand, and remember, your inventoriable supplies are considered inventory. Just because you don’t keep finished goods on your shelf doesn’t necessarily mean you don’t have inventory (sorry!).
If you create products on demand and you don’t keep any supplies on hand, then you might truly have $0 of inventory. An example would be Paper + Spark, my own biz. I use a drop-shipper to fufill my orders, and do not create a mug or a journal until someone orders it. I truly do not keep any supplies or inventory on hand, since my business is made-to-order digitally designed products. However! I still do have cost of goods sold.The really important part – Why does any of this matter?
I’ve been telling you all about what inventory is and isn’t, but I haven’t really explained why it’s so important to be keeping track of it. Inventory matters for tax purposes. Here’s the bottom line – you cannot deduct the cost of your inventory until you sell it.
Let that sink in for a moment. What exactly does this mean?

You’re a business owner. You’re (hopefully) doing your tax return each year. Your biz spends money on all sorts of business expenses – printing, advertising costs, staples, beads, fabric, transaction fees, craft show booth rental, etc. At year-end, you are deducting most of these business expenses. Deductions are good. They are subtracted from your business income & sales so that you owe less in taxes. Yay! More deductions means less tax. For the most part, you can deduct these business expenses in the year you paid them.
But – you cannot deduct inventory OR those inventoriable supplies & materials until the year the item you created with that supply actually sells.
This is why you have to keep track of your inventory! Think about it. When I first started selling jewelry, I went buckwild buying beads, crystals, and sparkly things galore. I probably bought more supplies than I could make jewelry with in a decade. How nice would it be if I could just deduct the cost of all those shiny things on my tax return? If I had the money, I could just buy supplies all day and never have to pay a dime in taxes for my biz.
This isn’t how it works. Unfortunately, you can’t just go out and buy a bajillion dollars worth of beads and then deduct that in the year you bought them. You have to wait until the items you create with those beads actually sell, then you get the deduction.
When you buy the beads, they become part of your inventory amount (remember, valued at cost). Your inventory amount is essentially, for accounting purposes, considered an asset. It just sits on your “books” as an asset, until you sell the item. Then, it becomes a deduction in the form of cost of goods sold on your tax return.
Each year on your tax return you will fill out a little section on your inventory and cost of goods sold. We’ll cover this in part 2, along with exactly how that cost of goods sold deduction works and how to keep track of it.
BTW, inventory is perpetual.
That means it’s something you keep track of over time, across years. Unlike your regular ol’ expenses, you don’t just go back to zero on January 1. You will need to know your inventory amounts at year end, and then that amount rolls over to the next year, and you keep building or subtracting. You have to do it this way because in real life, you will be selling items that you created last year. Or you might be making items this year with supplies that you bought 3 years ago. Thus, inventory is perpetual.
Keep truckin’…
What questions do you still have about inventory? If you’re ready to set up a system to accurate record those inventoriable supplies, calculate the cost of goods made for your creations, and track inventory and COGS totals, then check out our bestselling Inventory for Handmade Sellers spreadsheet. This template will get you ready for tax time.
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.
Now that we’ve covered inventory, let’s delve into cost of goods sold and what actually goes on your tax return. Click here to read part 2, all about cost of goods sold
All information on this site is provided for general education purposes only and may not reflect changes in federal or state laws. It is not intended to be relied upon as legal, accounting, or tax advice. We strongly encourage you to always consult with a tax or accounting professional about your specific situation before taking any action. Please read our full disclaimer regarding this topic.
I have two questions. What if you have supplies that you have previously purchased but you don’t know the cost because you don’t have a receipt? Say you have an item you purchased 3 years ago and you do have a receipt can you still plug what you spent on the sheet for inventory? Thanks
Hi Amanda! This is a great, frequently asked question. The answer is it depends. If you want to be able to accurately price your product (based on how much it cost you to make), then yes, you should input the price of the supply, or at least an estimated cost of the supply. However, for tax purposes, without a receipt to back up your supply cost, you really shouldn’t deduct any amount for COGS when that finished good sells. So basically, to make things really complicated, I’d say yes – enter a cost for pricing and bookkeeping purposes, but no – enter zero cost for tax and COGS purposes.
So I repurpose fabrics into aprons and suchlike, using a lot of stuff that was given to me. Mostly I buy thread and a few snaps. Sometimes I buy jeans at a thrift store, but I can conceivably make two aprons, two bowl cozies, two bibs,and maybe a potholder or two out of that one pair of jeans. How do I figure inventory or cost of goods on that?
When you purchase things like the jeans, you’d want to record its total cost and approximate how many square inches you’ve got. Then as you make things, you can measure about how many square inches when into the cozy, the bib, etc. to get the cost of jeans in that product. If the item was given to you, then it’s got a cost of $0. So for TAX purposes at least, you don’t have to deal with cost of goods sold for that.
Thank you for this article. Very helpful!
Quick question: how do I handle/account for materials that I use in prototyping, early designs, or even in products that I end up scrapping for whatever reason (not every item comes out perfect 🙂 )? There are some specific materials I use exclusively to prototyping so I suppose it’s easy enough to always just put down as a regular expense, but as I transition towards the final design, I begin using material (generally wood) that would also be in products I would sell. I’m unclear how those materials that are not used in the making of sellable product are accounted for. This question could also be extend to unusable scrap/waste product…
I’m moving away from reselling items with discrete inventory items to crafting, and this “material as inventory” has me a bit mystified and somewhat overwhelmed!
GREAT INFORMATION FOR NEWBIES…THANK YOU…
Thank you. I still have a question. What about a writer? The books that I published are in physical form and I own those books. The only cost I paid are printing cost. How do I account the books as inventory?
Hi Janet,
Great article, thanks! Question: should I include an allocation of overhead in my cost of goods made? (I make jewelry at home and sell it online.)
Thanks!
I do machine embroidery. In fact the design made out of thread is a large part of any item I would sell and per what I read that means it should be inventoried. How could that even happen?
Thank you so much for this post! I came across it in a search for how to keep track of my bow making supplies. So helpful and very inspiring!
Thanks for this wonderful piece of work it was helpful during my interview.
Hi, I just started my Etsy shop in November, so I am getting ready to file my first tax return as a sole proprietor. I am confused about inventory. I was reading on Publication 538 on the IRS website and it says under section Inventories there is an exception for small business taxpayers it states
“If you are a small business taxpayer (defined below), you can choose not to keep an inventory, but you must still use a method of accounting for inventory that clearly reflects income. If you choose not to keep an inventory, you will not be treated as failing to clearly reflect income if your method of accounting for inventory treats inventory as non-incidental material or supplies, or conforms to your financial accounting treatment for inventories. If, however, you choose to keep an inventory, you generally must use an accrual method of accounting and value the inventory each year to determine your cost of goods sold.”
I will be using the cash method of accounting and I qualify as a small business taxpayer according to the IRS, so if I understand correctly I should be able to account for inventories as non-incidental materials or supplies and therefore can be deducted under business expenses. Is this correct? I want to make sure I am complying. I purchased your Etsy seller spreadsheet and am just beginning to enter last years receipts so I just want to make sure I understand correctly before I get to far.
Thank you,
Here’s the kicker with this confusing language – the IRS is saying you can “treat inventory as non-incidental materials or supplies” if you’re a small business taxpayer.
Great, so how do they then define treating non-incidental materials or supplies? First, what’s a non-incidental material or supply? It’s basically your inventoriable materials & supplies. Incidental means minor, so non-incidental is your non-minor supplies, ie – the stuff you sell.
Next, how/when does the IRS say we can deduct non-incidental supplies? They require us to deduct the cost of non-incidental materials and supplies at the LATER OF when you bought the product or when it’s used/consumed…the LATER OF being the kicker. So here we are, back full circle, to not being able to deduct them until the year they are sold (since usually they are sold after they are purchased by you). Clear as mud, I know, but even as cash basis taxpayers, it boils down to deducting your inventory costs in the year of sale, not necessarily the year of purchase.
How do you use the inventory template year to year? I think you have specific dates on it
Hi there, if you have the inventory cost & pricing spreadsheet it does have dates on it. It’s made to be used year after year. If you need new year tabs on your file, just save it & email it to us. We can add a 2020, 2021, etc. tab to your file so you can keep using it.
There is probably a really simple answer here, but I know I need to account for the total cost to me of each raw material inventory item in my cost per unit,and, as far as I understand it, that would include accounting for the sales tax pain on those items. I remember in one of your videos (can’t recal which one) that you mentioned using some sort of weighted method to figure it out if you have an order or receipt with lots of items on it, but I cannot for the life of me figure out how to do that. I have some purchases with 30+ items on them and I’ve no idea how best to distribute the sales tax to all the items, and also account for discounts and coupons that are pulled off the total rather than individual items on the receipt.
Thanks!
Applying the discounts can be tricky because it depends how the retailer applied it – a % off all items, only on certain items etc. But for sales tax…rather than attempting weighted average (which would be overly complicated), why not just apply the sales tax rate to each individual item’s price?
Very organized I need to be more organized
Thank you so much for all the helpful information you have published. As a total newbie, it has been extremely helpful. I have a question about digital products that I recently started selling on Etsy. I create original artwork on paper or canvas and then digitize it and sell only the digital art. I know you’ve said that there is no inventory or cost of goods sold for digital items, but I feel my products are a type of hybrid as they are not created digitally. I do incur the cost of all the physical supplies in order to create my digital products, but I’m not sure if or how the expenses/inventory should be handled. Thank you in advance for any advice you can provide.
Hi Jennifer, if you’re selling solely digital prints you wouldn’t have inventory. BUT that doesn’t mean you couldn’t possibly deduct the supply expenses you use to create the original piece of art (prior to digitizing) as a potential business expense.
I’m so lost. I’m 67 years old on measly social security income. I decided to open an Etsy store to sell my stash of vintage stuff and my own collectibles. Long story short, in 2020 I sold 21,000. Other than my actual receipts for items I found at thrift stores, how do I give a value on inventory I’ve had for years just decorating my house? Things from my mom and grandma? Things from estate sales without itemized, receipts?
I have receipts for a printer I bought, plus everything else. But clueless on my decades old stuff that is now part ofy inventory?
This is my first time filing taxes as I made less than 20k on my social security income and didn’t have to file.
Can you help me? I had so much fun selling and the extra money helped so much. I want to keep doing it as long as I can and do it all correctly following tax law.
THANK YOU so much!!
Berti
Hi Berti, congrats on some awesome sales last year! If you don’t have receipts for those inventory items and/or you didn’t actually buy them anyway, for tax purposes they are worth $0. They are still inventory but you basically get a $0 cost of goods sold deduction when you sell them. This means you’re taxed on the full sale of that item but it at least makes doing your inventory paperwork easier.
I’m a thrifty shopper for my craft business always looking for the best deal to find things to use to make my repurposed bags and purses. I have recently purchase a huge grab bags of combined items of different value very cheaply. All are usable to me and such an excellent deal. How is the correct way to figure out the cost of any one particular thing? Keep in mind also it is a combination of inventoriable and non-inventoriable things. Do I count the number of items and divide the price by that much? Even if these are things that don’t have the same value normally? And if some things are packaged together are they one item or 5 items? It is around 200 items more or less costing me about 35 bucks. I love the deal, but it seems like a book keeping nightmare.
I think you just divide up the best you can. By number of items may be the best you can do, even though it doesn’t totally make sense on a per item level. You could also do something like by weight if that made more sense.
Will the IRS take a Hobby Lobby receipt as proof of purchase for a deduction? They do not show what you purchased.
My wifes business is making jewelry from stone beads. We have 10’s of thousands of individual beads to account for. This seems like an impossible task given the size and scope of her business. Each bracelet sold may have 30 different beads each. Keeping track of sales (many are at live events, we dont have any fancy software) is done on paper.
Seems like we are ripe to fail in tracking inventory. What suggestions are there when you have so much inventory on hand and its so cumbersome to track once a bracelet is made and sold.
Okay…. I’m just getting started learning about and understanding inventory; even though I’ve been in business for years (whoops).
I’m a glass artist. I buy my glass/raw materials in all sorts of shapes, sizes, and textures. There’s also a fair amount of ‘scrap’ glass that’s leftover from various projects. I buy full sheets of glass and may use a centimeter, an inch, or a sliver in my creations. I also use various types of frit that can be powder, fine, medium, or coarse grit/size that is sold in either 5oz, 1lb, or 5lb jars.
How in the world am I supposed to know the value/cost of each variable while I’m creating art?
I’m starting to understand the concept of finished inventory, but costing each piece of art out just boggles me.