If you are a small handmade business, calculating your Costs of Goods Sold (COGS) can be one of the most difficult things to figure out come tax time. We guide you through this tricky bookkeeping topic and give you some tips on how to organise your records in order to make it super simple.
What is COGS?
Let's start with the very basics: COGS is shorthand for your "Cost of Goods Sold". Essentially, this is what it cost you as a business to create the products you sold in the financial year.
The "cost" part of COGS is mainly tallied from the materials you purchased to create your product: for example, if you make ceramic products your COGS would mainly be calculated from the cost of your clay. If you make dresses, then your COGS would primarily be from your fabric, zips and buttons.
Not all costs are included in this calculation, so you can't for example include the cost of your labor, your rent or your subscriptions in this calculation. This is because they are seen as not directly related to making your products (in accountant speak, this is known as an "indirect cost"). Read more about the difference between indirect and direct costs here.
The IRS requires all sole proprietors / partnerships to submit details about their COGS via a form called a "1040 Schedule C". To read more about how to complete a Schedule C for handmade sellers, please see our blog post here: Schedule C: An Instuction Guide »
Why should I bother with COGS?
As a handmade seller, it's important to realise that from an IRS perspective, you are seen as a "manufacturer" rather than a seller of goods or services. This means that the tax man will be expecting to see a significant amount of your expense deductions as part of your COGS: in other words, most of your costs of running your business are in buying the materials to make your products. If you don't have the expense deductions in Part III of your Schedule C to match this expectation, then it can possibly invite the possibility of tax audits and further scrutiny.
Other than the threat of the tax man breathing down your neck, there are actually some great benefits to tracking your expenses as COGS - especially if you are in the "growth stage" of your small business.
Tracking and claiming your material usage as COGS allows you to purchase your materials in bulk / ahead of time without needing to use them in the financial period. This means you can purchase your materials now, or whenever you need to and gradually offset your costs against your revenue as you grow.
Using a quick example to illustrate this point, Susan purchases $10,000 of material stock in the first year of her business but only uses $2,000 in manufacturing her products - leaving her with a leftover $8,000 material "stash".
If claimed as a straightforward deductible expense, the $10,000 would completely be claimed in year 1 of the business against the minor revenue made in year 1 which wouldn't have much of a positive impact for her tax situation. In year 2, as it has already been fully claimed, $0 of the value of this stock can now be claimed against year 2 revenue even though it has been used to create a proportion of the products sold in this period. If Susan experiences good growth in her business in Y2 and uses the $8000 of materials, absolutely none of the value of it can now be offset against the now significant revenue for this year as it has already been claimed - this can add up to significant loss of deductions and a heftier tax bill as you are trying to build your business.
How to calculate COGS
The IRS sets out how it wants you to calculate this figure via the form itself. You'll need to know 6 different COGS calculations and then enter them on separate lines to get your final tally:
- Start of Year Material Inventory Value
- Purchases (Less Personal Use)
- Cost of External Labor
- Materials & Supplies (these are not your materials in most handmade cases as they are factored into 1 and 6)
- Other Costs (Overheads)
- End of Year Material Inventory Value
For starters, make sure that you keep records of all material purchases made and also keep track of how much of each material was used in your products. Specialised handmade inventory tracking software like Craftybase can make this task much easier, as it automatically calculates your material usage for everything you make and keeps track of your raw material inventory on your behalf - it even generates all the numbers you need for your Schedule C automatically!
Your total COGS should include all materials and effort that went into getting your product into a saleable condition. For handmade businesses, this essentially can be:
Cost of Materials: This is the total amount of money you spent in obtaining the materials you needed to create your product. This should include any shipping costs you have paid in order to have the material delivered to you. Examples: fabric, thread, and beads.
Cost of Packaging: This is the cost of packaging up your product. Examples: jewelry boxes, fancy labels, ribbon to tie together soap bars.
An important distinction to make on this one: this should not include any packing materials (e.g the cardboard box you ship the product in) these can normally be claimed as expenses, but should not be included in your cost of goods sold.
When should I claim for COGS?
For accounting purposes, COGS are treated as an expense in the period the business recognizes income from sale of the goods. This means that you should claim the cost only in the year that your product was sold.
Can I include my labor in the COGS calculation?
In the US, claiming of hired labour costs (i.e. not your own labor) can be included in the calculation, however any of your own internal labor costs cannot be included in COGS.
Does Cost of Goods Sold include transaction or listing fees?
Usually no - selling fees (such as Etsy Listing fees or PayPal transaction fees) are best categorised and claimed as "selling expenses" as they are usually generated after the product has been made ready for sale. This rule can vary depending on your country of residence, so it's worth checking with your financial authority to make sure.