As a handmade seller, one of the first things to realise is that you are not just a retailer of your goods - you are also a manufacturer of them.

Why does this matter? Well for starters, it changes everything about the way you need to report your end of year revenue and expenses to the IRS.

"Significant" Inventory Costs and Your Business

As a manufacturer, you are assumed to have "significant inventory costs". The word "significant" is one that often causes confusion, especially for small handmade business: significant doesn't mean that you have tens of thousands of dollars worth of inventory, all it means that your inventory costs are significant in relation to your revenue. Most, if not all, craft businesses are deemed to have significant inventory costs, regardless of their revenue.

As a business with significant inventory, the taxman expects you to be reporting your direct material costs as part of your COGS ("Cost of Goods Sold"). For sole proprietors, this is reported on your annual Schedule C form (see here for details on how to complete a Schedule C form).

What is COGS?

So, what exactly is "COGS"? COGS is short for "Cost of Goods Sold" which is essentially the cost of all the materials you used to create the products you have sold within the financial year.

This is calculated using your start and end of year material inventory values, along with purchases and drawings for personal use made during the year (for a detailed rundown of how COGS is calculated see How do I calculate my Cost of Goods Sold?)

You can either calculate the COGS figures yourself using your records in a spreadsheet, or a much easier option is to use specialised inventory software for manufacturers like Craftybase Inventory + Bookkeeping or Quickbooks Manufacturing and Wholesale Edition.

Advantages of COGS

Calculating your expenses using the COGS approach has many advantages for small business, not just tax compliancy. For one thing (which is a huge thing), it can regulate your revenue and expenses to provide you with predictable tax liabilities.

Let's go through an example to illustrate: let's say you open your Etsy shop in 2015. You purchase $10,000 of materials during this year to build your material inventory to ensure that you can handle demand. Sales aren't quite as expected during your first year, so you still have quite a bit of your materials in stock, along with some finished products.

When tax-time rolls around, you complete your return stating a supply expense of $10,000 on sales of $2,000.

Skipping ahead to year 2, sales start to pick up - great news! You make $15,000 in the next year in sales, but only purchase $2,000 in stock due to the excess of materials you already had on hand from year 1.

Claiming the expense of $2,000 on your tax return against the $15,000 means that after one of your biggest deduction categories have been applied you still have $13,000 in pure business income that will be taxed.

Tracking your materials as indirect expenses

Here, you should already be seeing the issue: as you have claimed your materials as a deduction in the year you purchased them, you have lost the ability to claim and offset against their eventual sale later down the track.

Let's look at the COGS approach now for the same situation. For the sake of simplicity, we'll use a guideline of COGS being 45% of your sale price (it's however a little more involved than a simple percentage calculation: see here for more detail on how to calculate your COGS)

In year one, as sales were relatively low your COGS will also be low - remember that your COGS can never be higher than what you have sold. On your sales of $2,000, you will claim COGS of $900.

In year two, your $15,000 in sales will be offset by a COGS deduction of $8,250. Comparing to the direct expense example above, you have been able to claim $4,750 more in deductions in your second year.

Tracking your material expenditure as COGS

Tracking your material expenditure as COGS using an inventory tracker like Craftybase as you can see in the diagram above means that you always have a direct relationship between your revenue and your expenses - as your revenue increases, the cost of manufacture increases (you make and sell more products). This means that you are always claiming a constant amount of expenses against your revenue and can estimate your liabilities with much more confidence going forward.

Please note that tax laws change frequently. This information is for educational and informational purposes only should not be construed as tax or legal advice. Please consult a licensed financial expert in your area with specific questions or concerns.