Cost of Goods Sold: What Counts and How to Calculate It
Cost of goods sold (COGS) is beginning inventory, plus purchases (less returns and anything you took for personal use), plus freight-in and other qualifying costs, minus ending inventory. IRS Publication 334, the tax guide for sole proprietors, lays this out on Schedule C lines 35 through 42. COGS is subtracted from your net receipts to get gross profit, before any operating expenses. The rules below come from the 2025 edition of the publication and the 2025 Schedule C instructions, read in October 2026; the $31 million small-business threshold is indexed for inflation and changes by year.
1. The formula, line by line
Pub. 334 says that if you make or buy goods to sell, you deduct COGS from gross receipts, and that you must value inventory at the beginning and end of each tax year to get there.
| Schedule C line | What goes there |
|---|---|
| 35 | Inventory at beginning of year |
| 36 | Purchases, less items withdrawn for personal use |
| 37 | Cost of labor (not what you pay yourself) |
| 38 | Materials and supplies |
| 39 | Other costs |
| 40 | Add lines 35 through 39 |
| 41 | Inventory at end of year |
| 42 | COGS: line 40 minus line 41 |
Opening inventory should usually equal last year's closing inventory. If it does not, the IRS says to attach an explanation.
2. What belongs in purchases
- Use the price you actually paid. The IRS says trade discounts reduce your cost of purchases; use the price paid, not the stated price.
- Subtract supplier returns. Pub. 334 says you "must deduct all returns and allowances" from total purchases.
- Take out personal use. Merchandise you or your family take for personal use must be excluded from purchases.
- Add freight-in. The IRS says freight-in on merchandise you purchase for sale is part of COGS.
- Packaging depends. Containers that are an integral part of a manufactured product are COGS. Otherwise, their cost is a shipping or selling expense.
Labor and overhead usually matter only if you make the product. Pub. 334 says small merchandisers "usually do not have labor costs that can properly be charged to cost of goods sold."
3. A worked example
Assume a shop that buys and resells finished goods, with these made-up figures for one year:
- Beginning inventory: $3,200
- Purchases: $9,400
- Returned to suppliers: $300
- Taken home for personal use: $120
- Freight-in: $450
- Ending inventory (counted and priced): $4,100
- Gross receipts: $21,000
- Refunds and allowances to customers: $600
Net purchases: 9,400 - 300 - 120 = $8,980. Goods available for sale: 3,200 + 8,980 + 450 = $12,630. COGS: 12,630 - 4,100 = $8,530. Net receipts: 21,000 - 600 = $20,400. Gross profit: 20,400 - 8,530 = $11,870, which is 58.2% of net receipts.
Pub. 334 uses this same structure in its illustration, where returns and allowances are subtracted from gross receipts first, then COGS.
4. A quick accuracy check
Pub. 334 suggests a test for retail and wholesale businesses. Divide gross profit by net receipts, then compare the result with your markup policy. Little difference suggests the numbers are right; a large gap may mean sales, purchases or inventory were mis-recorded. In the example, a 58.2% gross profit compared with a shop that aims for a 60% gross margin is a small gap. If the shop aimed for 40%, the 18-point difference would be worth investigating.
5. Do you have to keep an inventory?
Pub. 334 says a "small business taxpayer" can choose not to keep an inventory. That means average annual gross receipts of $31 million or less for the prior three tax years, and not being a tax shelter. You must still use an accounting method for inventory that clearly reflects income. If you do keep an inventory, you generally must use an accrual method and value it every year. The IRS recommends inventory forms with description, quantity, unit price and value, and a record of who counted and priced.
The method for valuing inventory must follow generally accepted accounting principles for similar businesses, and be applied consistently year to year. Changing your inventory method requires Form 3115.
6. Key takeaways
- COGS = beginning inventory + purchases (net of returns and personal use) + freight-in and other qualifying costs - ending inventory.
- Use prices actually paid, after trade discounts.
- Supplier returns reduce purchases; personal-use items come out entirely.
- Gross profit is net receipts minus COGS, before operating expenses.
- Check gross profit percentage against your pricing policy to catch recording errors.