| Pub. 334, Tax Guide for Small Business |
2004 Tax Year |
Chapter 6 - How To Figure Cost of Goods Sold
This is archived information that pertains only to the 2004 Tax Year. If you
are looking for information for the current tax year, go to the Tax Prep Help Area.
Introduction
If you make or buy goods to sell, you can deduct the cost of goods sold from your gross receipts on Schedule C. However, to
determine these costs,
you must value your inventory at the beginning and end of each tax year.
This chapter applies to you if you are a manufacturer, wholesaler, or retailer or if you are engaged in any business that
makes, buys, or sells
goods to produce income. This chapter does not apply to a personal service business, such as the business of a doctor, lawyer,
carpenter, or painter.
However, if you work in a personal service business and also sell or charge for the materials and supplies normally used in
your business, this
chapter applies to you.
If you must account for an inventory in your business, you must generally use an accrual method of accounting for your purchases
and sales. For
more information, see chapter 2.
Figuring Cost of Goods Sold on Schedule C Lines 35 Through 42
Figure your cost of goods sold by filling out lines 35 through 42 of Schedule C. These lines are reproduced below and are
explained in the
discussion that follows.
| 35 |
Inventory at beginning of year. If different from last year's closing inventory, attach explanation
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| 36 |
Purchases less cost of items withdrawn for personal use
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| 37 |
Cost of labor. Do not include any amounts paid to yourself
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| 38 |
Materials and supplies
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| 39 |
Other costs
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| 40 |
Add lines 35 through 39
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| 41 |
Inventory at end of year
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| 42 |
Cost of goods sold. Subtract line 41 from line 40.
Enter the result here and on page 1, line 4
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Line 35 Inventory at Beginning of Year
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. If you
are a manufacturer or producer, it includes the total cost of raw materials, work in process, finished goods, and materials
and supplies used in
manufacturing the goods (see Inventories in chapter 2).
Opening inventory usually will be identical to the closing inventory of the year before. You must explain any difference in
a 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 deduction is the
smaller of its fair market value on the day you contributed it or its basis. 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 of goods sold.
If the cost of donated inventory is not included in your opening inventory, the inventory's basis is zero and you
cannot claim a charitable
contribution deduction. Treat the inventory's 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 goods sold for that year.
Example 1.
You are a calendar year taxpayer who uses an accrual method of accounting. In 2004 you contributed property from inventory
to a church. It had a
fair market value of $600. The closing inventory at the end of 2003 properly included $400 of costs due to the acquisition
of the property, and in
2003, you properly deducted $50 of administrative and other expenses attributable to the property as business expenses. The
charitable contribution
allowed for 2004 is $400 ($600 - $200). The $200 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 use in determining gross income for 2004 must not include
the $400. You remove that
amount from opening inventory for 2004.
Example 2.
If, in Example 1, you acquired the contributed property in 2004 at a cost of $400, you would include the $400 cost of the
property in figuring the
cost of goods sold for 2004 and deduct the $50 of administrative and other expenses attributable to the property for that
year. You would not be
allowed any charitable contribution deduction for the contributed property.
Line 36 Purchases Less Cost of Items Withdrawn for Personal Use
If you are a merchant, use the cost of all 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.
Trade discounts.
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 the stated prices) in figuring your cost of purchases. Do not show the discount amount separately as an item
in gross income.
An automobile dealer must record the cost of a car in inventory reduced by a manufacturer's rebate that represents
a trade discount.
Cash discounts.
Cash discounts are amounts your suppliers let you deduct from your purchase invoices for prompt payments. 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.
Whichever method you use,
you must be consistent. If you want to change your method of figuring inventory cost, you must file Form 3115, Application
for Change in Accounting
Method. For more information, see Change in Accounting Method in chapter 2.
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 discounts.
Purchase returns and allowances.
You must deduct all returns and allowances from your total purchases during the year.
Merchandise withdrawn from sale.
If you withdraw merchandise for your personal or family use, 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 should
charge the amount to your
drawing account.
A drawing account is a separate account you should keep to record the business income you withdraw to pay for personal
and family expenses. As
stated above, you also use it to record withdrawals of merchandise for personal or family use. This account is also known
as a “ withdrawals
account” or “ personal account.”
Labor costs are usually an element of cost of goods sold only in a manufacturing or mining business. Small merchandisers (wholesalers,
retailers,
etc.) usually do not have labor costs that can properly be charged to cost of goods sold. In a manufacturing business, labor
costs properly allocable
to the cost of goods sold include both the direct and indirect labor used in fabricating the raw material into a finished,
saleable product.
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 that does not have
any immediate or direct
connection with making the saleable product, but that is a necessary part of the manufacturing process.
Other labor.
Other labor costs not properly chargeable to the cost of goods sold can be deducted as selling or administrative expenses.
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 under Line 39 Other Costs.
Line 38 Materials and Supplies
Materials and supplies, such as hardware and chemicals, used in manufacturing goods are charged to 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.
Examples of other costs incurred in a manufacturing or mining process that you charge to your cost of goods sold are as follows.
Containers.
Containers and packages that are an integral part of the product manufactured are a part of your cost of goods sold.
If they are not an integral
part of the manufactured product, their costs are shipping or selling expenses.
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 cost
of goods sold.
Overhead expenses.
Overhead expenses include expenses such as rent, heat, light, power, insurance, depreciation, taxes, maintenance,
labor, and supervision. 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 lines 35 through 39 equals the cost of the goods available for sale during the year.
Line 41 Inventory at End of Year
Subtract the value of your closing inventory (including, as appropriate, the allocable parts of the cost of raw materials
and supplies, direct
labor, and overhead expenses) from line 40. Inventory at the end of the year is also known as closing or ending inventory.
Your ending inventory will
usually become the beginning inventory of your next tax 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 goods sold during the tax year.
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