The popularity of online markets such as eBay and Etsy has resulted in an expansion of businesses that transact through these markets. Some businesses operate exclusively through online retail, taking advantage of a worldwide target market and low operating expenses. Though nontraditional, these businesses are still required to pay taxes and prepare financial documents like any other company. They should also account for their inventories and take advantage of tax deductions like other retailers, including listings of cost of goods sold (COGS) on their income statement.
Key Takeaways
- Small businesses that transact through online markets such as eBay and Etsy are similar to other traditional businesses in being required to pay taxes and prepare financial documents.
- Cost of goods sold (COGS) for online retailers may be similar to those of traditional retailers.
- Anything not part of the cost of producing a good is not a COGS. For online retailers, examples include things like the bubble wrap, tape, and cardboard used to ship a product, as well as the shipping itself.
- Companies are allowed to deduct the COGS for any products they either manufacture themselves or purchase with the intent to resell, according to the IRS, provided the business lists COGS on its income statement.
Cost of Goods Sold (COGS)
COGS is the accounting term used to describe the expenses incurred to produce the goods sold by a company. These are direct costs only, and only businesses with a product to sell can list COGS on their income statement. When subtracted from revenue, COGS helps determine a company’s gross profit. The most common way to calculate COGS is to take the beginning annual inventory amount, add all purchases, and then subtract the year-ending inventory from that total.
Examples of what can be listed as COGS include the cost of materials, labor, and the wholesale price of goods that are resold, such as in grocery stores, overhead, and storage. Any business supplies not used directly for manufacturing a product are not included in COGS.
Cost of Goods Sold (COGS) and Online Retailers
Though operating differently than traditional retail companies, online businesses can claim most of these same costs. For example, a business that builds and sells a widget through eBay (EBAY) may list any raw materials used to create the widget as a COGS. When those raw materials are shipped to the place of business, even a home, the shipping costs count toward COGS.
If a business has no real costs of production and only engages in the purchasing and reselling of goods over the internet, it may still list the amount spent on purchases as COGS. Packaging may even be included, but only so long as the packaging is unique and resembles what would appear on a shelf in a physical location. The bubble wrap, tape, and cardboard used to deliver the widget to a customer are not COGS, nor is the cost of shipping to the customer. This is because these costs are not part of the costs of producing the good.
The Internal Revenue Service (IRS) allows companies to deduct the COGS for any products they either manufacture themselves or purchase with the intent to resell. This deduction is available to any business that lists COGS on its income statement, including manufacturers, wholesalers, and retailers, whether they operate in physical locations or only online.
Take, for example, a retail business that operates through Etsy (ETSY) and has less than $1 million in annual sales. It keeps track of inventory, such as unused materials, unsold goods, etc. Under these circumstances, IRS Publication 334: Tax Guide for Small Business details how the business can use the cash method of accounting to deduct inventory expenses. If supplies are imported for the Etsy seller, then any taxes, commissions, duties, or other associated fees may count as COGS for IRS purposes. However, fees associated with online services such as PayPal may not be counted toward COGS. Additionally, the time spent marketing goods online does not count toward COGS.
Examples of General COGS for Online Businesses
COGS for online businesses can vary depending on the nature of the business. Not every company may have the costs listed in the bullets directly below, and note that brick-and-mortar or in-person stores may also incur similar type COGS:
- Product Costs: Product costs are the direct cost of purchasing or manufacturing the products being sold. These are the costs retailers incur when buying goods they’ll later sell. This occurs when a distributor partners with a retailer.
- Raw Materials: Raw materials are the items used in manufacturing the products. If the online company makes their own goods, they’ll incur costs like wood, metal, plastic, or other materials that go into their product.
- Manufacturing Labor: Manufacturing labor are wages paid to workers involved in producing goods. This is usually the staff that directly put together or assemble the goods.
- Shipping Costs: Shipping costs are expenses associated with getting the products to customers. This could include freight or transportation costs for moving goods from suppliers to warehouses or from warehouses to customers.
- Utilities: The costs of utilities such as electricity and internet used in the manufacturing of products can also be included in the cost of goods sold. Keep in mind that a company must be able to trace the use related to making inventory as opposed to just keeping the business open in order to include in COGS.
Note
Keep in mind that COGS and inventory are inversely related. If a company has a higher COGS, that means it has a lower inventory cost (and vice versa). That’s because the cost that goes into making goods can either be expensed (COGS) or placed on the balance sheet (as inventory).
COGS and FIFO/LIFO
An online business may have the option between a few different inventory management methods. The two primary methods are called LIFO (Last In, First Out) and FIFO (First In, First Out).
Under the LIFO method, the cost of goods sold is calculated using the cost of the most recently acquired inventory first. This means that the inventory that was last purchased or produced is assumed to be sold first, while older inventory remains in stock. In times of rising prices, this results in higher COGS because the most expensive inventory is being allocated to sales, leading to lower reported profits and potentially reduced tax liabilities.
In contrast, FIFO assumes that the first inventory items purchased or produced are the first to be sold. This means that the cost of goods sold is calculated using the cost of the oldest inventory first, while newer inventory remains in stock. In periods of rising prices, FIFO typically results in lower COGS compared to LIFO because the lower-cost items from earlier inventory purchases are allocated to sales, leading to higher reported profits and potentially higher tax liabilities.
For an online business, the choice between LIFO and FIFO can have significant implications for financial performance and tax obligations. In addition, the method chosen can impact the valuation of ending inventory on the balance sheet, affecting financial ratios and investor perceptions of the company’s financial health. While a company should generally try to match the natural flow of its inventory and use specific identification if possible, it may choose to elect something else if it can substantiate the process.
Importance of COGS to Online Business
Let’s wrap up by quickly touching on why COGS matter to an online business. First, accurate COGS directly impacts the company’s profitability. A higher gross profit margin indicates better efficiency in controlling production or acquisition costs, leading to increased profitability. However, this means the company will have higher period costs if it chooses to expense costs in an immediate period rather than recognizing them as a product cost. This impacts how management or outside parties evaluate a company’s financial performance.
Second, precise COGS figures are essential for tax compliance and financial reporting. The IRS requires businesses to deduct COGS from gross revenue to determine taxable income. Incorrectly reported COGS can result in over or underpayment of taxes, potentially leading to audits, penalties, and interest charges. Moreover, accurately reported COGS ensures compliance with accounting standards and provides stakeholders, such as investors and lenders, with reliable financial information for making investment and lending decisions.
Thirdly, effective inventory management relies on accurate COGS calculations. For online companies, which may operate in competitive and rapidly changing markets with lower barriers to entry, efficient inventory management means not wasting time or resources on unnecessary items. Accurate COGS data enables businesses to make informed decisions regarding inventory levels, pricing strategies, and product offerings.
What Is Cost of Goods Sold (COGS)?
Cost of goods sold (COGS) includes any expenditure that was necessary for the manufacture of a product sold by a company. It is solely made up of direct costs and can reduce a company’s tax liability.
Is COGS the Same as Cost of Sales?
No, though they are analogous and often used interchangeably. Cost of sales applies to companies that do not manufacture a product, such as a retailer or wholesaler. It is the total costs incurred in providing the company’s service.
Are Operating Expenses Part of COGS?
No, they are not, because they are indirect costs. For example, suppose a business pays office rent. That cost does not contribute to the manufacturing of the business’ product, so it is not part of COGS.
The Bottom Line
Cost of goods sold (COGS) is an important line item on an income statement. It reflects the cost of producing a good for sale to a customer. The IRS allows for COGS to be included in tax returns and can reduce your business’ taxable income. Whether you are a traditional retailer or an online retailer, the same rules apply.
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