Online markets, such as eBay and Etsy, are so well-known that a lot of businesses operate on the internet. This allows them to benefit from a global marketplace and have minimal operating costs. Even though they aren’t conventional, these businesses must still make payments to the government and create financial statements like every other business. They also need to account for their inventory and make use of tax deductions just like other retailers, and include the costs of sales (COGS) in their financial statements.
COGS stands for Cost of Goods Sold
COGS is an accounting term used to define the expenses that are for the creation of the products offered by a company. They are direct costs only that are incurred by businesses that have an item to sell and are able to include COGS on their income statement. When subtracting revenue from COGS, COGS helps determine a business’s gross profit. The most popular method to determine COGS is to calculate the inventory value at the beginning of each year by adding all purchases before subtracting the year’s end inventory from the total.
Examples of what could be classified as COGS include the cost of labor, materials, and the wholesale cost of products that are sold on a resale basis, for example, in supermarkets, overhead, storage, and other stores. Anything that is used by businesses but not to manufacture a product is not counted in COGS.
Web retailers and the cost of goods sold (COGS)
While they may operate in a different manner than traditional retail businesses but online businesses are able to benefit from the same expenses. For instance, a company that creates and sells widgets through eBay (EBAY) might declare the raw materials used in order in the creation of the widget as COGS. If the raw materials are transported to the business’s location or home, and the shipping cost is a factor as COGS.
If a company does not have actual production costs and instead is involved in purchasing and reselling items online, it could be able to list the cost as COGS. Packaging could also be listed however only as in the event that it’s unique and matches what you would see on a display in a physical store. The bubble materials used give the widget to the customer aren’t COGS nor is the cost of shipping. The reason is that the costs aren’t directly related to the production of the product.
The Internal Revenue Service (IRS) permits companies to deduct COGS for any product they make or buy with the intention of selling. This deduction is offered to any company that has COGS on its income statement that includes wholesalers, producers, and retailers, regardless of whether they are operating in physical locations or solely online.
Consider a retailer that operates on Etsy (ETSY), which has lower than 1 million annual revenue. It records inventory items, including items that aren’t being used, unsold products, and other items. In these instances, IRS Publication 334: Tax Guide for Small Business details the ways that businesses can employ the method of accounting using cash to deduct the cost of inventory. If the importation of supplies is to support Etsy, and the imports are for an Etsy vendor, tax, commission, duty, and other associated charges could be counted in COGS for IRS purposes. However, any fees that are associated with online services like PayPal are not included in COGS. Furthermore, the time you spend selling goods online doesn’t count towards COGS.
General COGS Examples for Internet Businesses
COGS for businesses that are online can vary based on the company’s needs. There are many different companies that may incur the same costs as those listed in the bullets below. Be aware that brick-and-mortar and in-person stores can also suffer COGS similar to the ones listed below:
- Costs of production: These are the direct costs of manufacturing or purchasing the items that are sold. These are the expenses retailers pay for the purchase of products they will later sell. This happens when a distributor collaborates with retailers.
- Materials that are raw: Raw materials are the elements used in the production of products. If a company creates its own products online, it’ll have to pay for costs such as metal, wood, or other substances that are used to make its product.
- Manufacturing: wages refer to the wages that workers receive in the process of making items. It is typically the workforce that makes or puts together the items.
- The cost of shipping is: Shipping costs are expenses that are incurred in delivering the product to the customers. It could be freight or transportation expenses for transporting products from warehouses to suppliers and from the warehouses back to clients.
- utilities: The costs of utilities, including internet and electricity that are used to manufacture products, are also added to COGS. Be aware that the company should be able to track the usage related to creating inventory, not just keeping the business operating, for the purpose of putting it into COGS.
FIFO/LIFO and COGS
A company that operates online could have the choice of several different ways to manage inventory. Two of the most common methods are known as LIFO (Last In First Out) and FIFO (First In First Out).
In the LIFO method under the LIFO method, using the LIFO method, COGS is calculated by calculating costs of the latest acquired inventory first. This means that inventory that was most recently purchased or manufactured is believed to it will be the most sold, even though older inventory remains in inventory. If prices rise, COGS remain higher because the inventory with the highest price is allotted to sales, which leads to lower profits reported and, in turn, lower tax liabilities.
FIFO is based on the assumption that the inventory items first bought or manufactured will be the first to be sold. This implies the COGS is calculated based on the cost of the inventory with the lowest value first, whereas the newer inventory is kept in inventory. If prices increase, FIFO typically results in lower COGS as compared to LIFO due to the fact that items with lower costs from earlier purchases of inventory are allocated to sales, resulting in higher profits and possibly higher tax obligations.
If you are a business that is online, the decision of LIFO and FIFO could have a significant impact in terms of financial performance as well as tax obligations. The process can affect the value of inventory that is ending in the balance sheet, which can impact the financial ratios of investors and their perceptions of the financial health of the business. Although a business should always strive to be in line with the circulation of their inventory and employ specific identification whenever possible, it could decide to opt for something different when it is able to prove the method.
The Value of COGS in Internet Business
Accurate COGS directly impacts the profitability of a company. A higher gross profit margin translates to greater efficiency in regulating the cost of acquisition or production and resulting in higher profitability. This means that the company will have more expenses in the period if it opts to deduct expenses immediately instead of recognizing them as a product expense. This can affect the way that management or other parties examine a company’s financial performance.
Accurate COGS figures are crucial to ensure compliance with tax laws in financial and tax reporting. The IRS demands that businesses subtract COGS from gross revenues to calculate the taxable income. If not properly reported, COGS could result in over- or under-payment of taxes, which could lead the company to penalties, audits, and interest costs. Furthermore, accurate reporting of COGS assures that the accounting is in compliance with standards and provides the stakeholders, including lenders and investors, with accurate financial information to assist in making lending and investment decisions.
A successful inventory management system relies on precise COGS calculation. For online businesses, which are in fast-changing markets with fewer obstacles to entry, effective inventory management results in spending less time and money on unnecessary purchases. The accuracy of COGS information allows companies to make educated decisions about the level of inventory and pricing strategies, as well as products available.
Which Industries Do Not Report COGS?
Industries that do not claim COGS are professional services such as lawyers, consultants, architects, and financial advisors, along with software firms and financial services insurance companies, educational institutions, and healthcare firms. These are businesses that do not manufacture and sell their own products to the public.
Are Cost of Sales and COGS interchangeable?
However, they’re similar and are often employed interchangeably. Cost of sales can be applied to those who do not produce a product, like wholesalers or retailers. It’s the total cost for providing the company’s service.
Does COGS Include Operating Expenses?
These are not, since they are indirect expenses. For instance, suppose that the business pays for office space. This cost is not a contribution to the production of the company’s product; therefore, it’s not a component of COGS.
Bottom Line
Cost of the goods sold is a crucial line element on the income statement. It represents the cost of creating a product to sell to a buyer. The IRS allows COGS to be incorporated into tax returns. This can help reduce your tax-deductible earnings of your company. No matter if you’re an established seller or an online one, the same rules are in place.
