Key takeaways
- COGS = beginning inventory + purchases and production costs − ending inventory.
- Sole proprietors report COGS in Part III of Schedule C, lines 35 to 42. See Publication 334.
- Freight-in (shipping to get goods to you) is part of COGS. Shipping orders out to customers is usually an operating expense.
- Only product sellers and makers have COGS. Pure service businesses generally don’t.
What is COGS?
If you sell products, COGS answers one question: what did the things you actually sold cost you? It doesn’t include everything you spent this year, only the cost tied to units that left your shelf. Unsold stock stays in inventory until it sells.
COGS matters because it drives gross profit, the money left to pay for everything else. If your COGS is too high, no amount of cost-cutting on software or ads will fix your margins; you need better supplier prices, less waste or higher selling prices. An Etsy seller, a Shopify store, a bakery and a contractor who resells materials all have COGS. A freelance writer or consultant usually doesn’t.
Track supply and inventory purchase receipts with the Manage Receipt app.
Formula
COGS = Beginning inventory + Purchases + Freight-in + Materials, supplies and direct labor − Ending inventory
This mirrors Part III of Schedule C: inventory at the start of the year, purchases less anything you took for personal use, cost of labor, materials and supplies, other costs, minus inventory at year end.
What’s included
| Receipt | COGS? |
|---|---|
| Wholesale products bought for resale | Yes |
| Raw materials and parts | Yes |
| Freight and shipping to receive inventory | Yes |
| Product packaging that ships with the item | Yes |
| Wages of people who make the product | Yes |
| Shipping orders out to customers | Usually not |
| Marketplace and payment fees | No |
| Rent, ads, software, office supplies | No |
Some small businesses that meet the IRS gross receipts test can use simpler inventory methods. Ask your tax preparer which method fits, and keep vendor receipts and invoices for every inventory purchase either way.
COGS vs OpEx
COGS rises and falls with sales: sell more units, spend more on inventory. That’s why it’s worth tagging every supplier receipt the day it arrives. A box of jars filed under “office supplies” moves money out of COGS and into OpEx, and your gross margin looks better than it really is. Operating expenses keep the business running whether you sell one item or a thousand. On a P&L, COGS sits right under revenue to give gross profit, and OpEx comes after that.
Example
An online candle shop’s numbers for 2026:
| Item | Amount |
|---|---|
| Beginning inventory (Jan 1) | $4,000 |
| + Wax, wicks, jars and scents | $10,000 |
| + Freight-in on supplies | $500 |
| + Gift boxes and labels | $600 |
| = Goods available for sale | $15,100 |
| − Ending inventory (Dec 31) | $3,500 |
| COGS | $11,600 |
With $25,000 in sales, gross profit is $25,000 − $11,600 = $13,400, a gross margin of 53.6%. Rent, ads and Etsy fees come out of that $13,400.
Tag supplier receipts as you buy
Scan or forward every supplier and freight receipt to Manage Receipt and put it in an inventory or materials category the day it arrives. At year end, your purchases total is already added up, so you only need the inventory counts to finish the COGS formula.
Explore AI Tax ReportsFrequently asked questions
Is shipping part of COGS?
Shipping to bring inventory or materials to you, called freight-in, is part of COGS. Shipping finished orders out to customers is usually treated as an operating or selling expense instead. Keep the two on separate categories so your gross profit isn’t distorted.
How do you calculate COGS?
Start with inventory at the beginning of the year, add purchases, freight-in, materials and direct labor, then subtract inventory left at the end of the year. The result is the cost of the goods you actually sold. Sole proprietors report this on Schedule C, Part III.
Do service businesses have COGS?
Usually not. A consultant, designer or writer sells time, not inventory, so their costs are operating expenses. Some service businesses track a “cost of services” for subcontractors or materials used on client jobs, but that’s an internal measure, not inventory-based COGS.
Is COGS tax deductible?
Yes. COGS reduces your gross receipts to give gross income, so it lowers your taxable profit. But you deduct inventory only when it’s sold, not when you buy it. Stock left on the shelf at year end is counted as ending inventory and carried into next year.