Cost of Goods Sold (COGS) for Handmade Products: What Counts

What counts as cost of goods sold for a business that makes what it sells?

Cost of goods sold (COGS) is what it cost to make the items you sold this year. With a formal inventory, unsold pieces are held at cost, never at the selling price, until they sell. For goods you produce, the regulation names raw materials and supplies, direct labor, and the indirect production costs needed to make the item, and it leaves out the cost of selling (26 CFR 1.471-3). On Schedule C the total is what you held at the start of the year plus the year's production costs, less what you still hold at year end (Part III).

A small business taxpayer on the materials-only method keeps only materials in COGS and deducts labor, rent and utilities as ordinary expenses; the sections below show both paths.

A maker's case is not simple when:

• earlier returns never counted unsold pieces, or your gross profit looks too high or too low;
• a helper, a second sales channel or wholesale has been added;
• the production space is part of your home or shared;
• the business is a partnership or corporation, which reports the figure on Form 1125-A instead of Schedule C;
• purchase records are missing.

Gather material purchases by month with invoices, pay records for anyone who helps make the product, a dated year-end count priced at cost, last year's closing inventory, rent and utility bills for the production space, and sales by channel. Where each figure goes on Schedule C is in the Schedule C cost of goods sold guide. If a case above is yours, the last section routes it to bookkeeping help.

Do raw materials and packaging that ships with the product count?

Raw materials do, and so does packaging that is part of what the customer buys. Publication 334 counts containers and packages that are an integral part of the product as cost of goods sold; packaging that is not integral is a shipping or selling expense. A candle's jar or a bag of coffee sold on the shelf is usually part of the product; a mailer used only to send an order is a shipping expense. Where the line falls depends on the facts.

In an inventory, the regulation includes raw materials and supplies that physically become part of the goods, and containers such as bottles and cases when title passes to the buyer with the contents (26 CFR 1.471-1). Supplies not used in making the product are deducted as business expenses when used (Publication 334). For packaging in more depth, and for freight, duty and sales tax on bought-in supplies, see landed cost in cost of goods sold.

Does your own time count as labor, and what about a helper you pay?

A sole proprietor's own time does not count. A helper's pay does when the helper makes the product and you keep a formal inventory; under the materials-only method it is an ordinary expense instead. Schedule C line 37 says not to include amounts paid to yourself (Schedule C). For a corporation or partnership, owner pay is a separate question for a professional (see the last section); wages to an employee who makes the product are direct labor (26 CFR 1.471-11).

Publication 334 counts the wages of employees who spend their time on the product, or the part of their wages you can determine if they work on it part of the time. The capitalization regulation, which does not reach a small business taxpayer, also counts contract employees and independent contractors as labor, and both it and the manufacturers' inventory regulation count payroll taxes on the pay as part of it (26 CFR 1.263A-1; 26 CFR 1.471-11). How a small maker treats a contractor's pay is a judgment to settle.

Pay for work that is not making the product, such as running a booth or keeping the books, is a selling or administrative expense (Publication 334). Whether a helper is an employee or a contractor is a separate question; see contractors who may be employees.

What about studio or kitchen rent, utilities, tools and equipment?

Studio or kitchen rent, utilities and insurance are production overhead, and how they reach your return depends on your inventory method. Publication 334 lists rent, heat, light, power, insurance, depreciation, taxes and maintenance as overhead that belongs in cost of goods sold when it is a direct and necessary expense of production. If the space also holds a shop counter or an office, only the production share belongs there.

• Formal inventory: production overhead is part of cost, so part of it sits in year-end value while pieces are unsold (26 CFR 1.471-3).
• Materials-only method for a small business taxpayer: only direct materials are inventory cost, so labor, rent, utilities and depreciation are deducted as ordinary expenses instead of carried in inventory (26 CFR 1.471-1).

Space in your home. With a formal inventory, the production share of home costs is an inventory cost, figured in Part III, and the Form 8829 instructions say to leave that area off the form. Under the materials-only method it is a business-use-of-home question, which generally needs space used exclusively and regularly for the business, so a kitchen the household also uses may not qualify (Form 8829 instructions). The home office guide covers the rest of the home.

Tools and equipment. A kiln, oven, roaster or sewing machine is equipment, recovered through depreciation or an expensing election, not a material. See writing off equipment in the first year.

Should finished paintings, candles or bags of coffee sit on the books as an inventory asset?

Yes, once you keep an inventory: unsold finished pieces are inventory, valued at cost and never at the price you hope to get. In the books they sit in an inventory asset account at cost, and a piece's cost moves to cost of goods sold only when it sells. Publication 538 lists raw materials, work in process and finished products as inventory, and Schedule C line 33 asks how you valued the closing figure: cost, lower of cost or market (a lower current value), or another method (instructions).

With a formal inventory, pieces left with a gallery or shop to sell for you stay in your inventory until title passes to the buyer (26 CFR 1.471-1).

A small business taxpayer can skip a formal inventory by treating inventory as non-incidental materials and supplies or by following its own books (Publication 334). Choosing to keep an inventory generally brings an accrual method for purchases and sales with it (Publication 334). Changing how you account for inventory generally means filing Form 3115 with the return for the year of the change, and a signed copy goes to the IRS by the day the return is filed (Instructions for Form 3115). Under the materials-only method, the cost reaches cost of goods sold in the later of the year the piece goes to a customer and the year the cost is paid or incurred (26 CFR 1.471-1). Which route fits, and what each does to the year the cost reaches profit, is in the materials and supplies or inventory guide.

Do you track raw materials, work in process and finished goods separately?

The return needs one total, but separate tracking is how you find each stage's cost on count day:

A year-end count covers all three. The regulation lists omitting stock on hand and carrying work in process at a nominal figure or below its proper value as methods that do not comply (26 CFR 1.471-2). Publication 334 suggests a count sheet with a description, quantity, unit price and value for each item, and a record of who counted and who priced.

Do the rules that add overhead to each item apply to a small maker, and what is the artist exception?

A small business taxpayer does not have to add the extra layer of overhead these rules require. The uniform capitalization rules make a producer add its direct costs and part of its indirect costs to the cost of each item instead of deducting them now (Publication 538). They reach costs beyond the production overhead a formal inventory already carries, such as purchasing, handling and storage, but not marketing, selling or distribution (26 CFR 1.263A-1; 26 CFR 1.471-11).

The limit is indexed each year, so IRS publications printed for an earlier year show a smaller figure. The exemption removes only that added layer. A formal inventory still carries production overhead such as rent and utilities, and you still value what you hold at cost, the same way every year (Publication 538).

The artist exception. The statute covers an individual in business as an artist, other than as an employee, whose own effort creates a picture, painting, sculpture, statue, etching, drawing, cartoon, graphic design or original print edition, judged by how original and unique it is and whether its aesthetic value outweighs its everyday use. Only expenses otherwise deductible that year qualify, and printing, photographic plates, film and similar costs do not (26 U.S.C. 263A(h)). It has a narrow rule for a corporation the artist and family own and says nothing about partnerships. Food and everyday-use items do not clearly fit, and a piece between art and craft is a question of facts. For a small business taxpayer the exception adds little; it matters mainly to an artist whose gross receipts are above the limit.

What workable system tracks one item's cost, per batch or per piece?

Add up what the piece or batch cost, then divide by the units finished. Use a card per piece for one-of-a-kind work such as paintings and commissions, and a sheet per batch for repeated runs such as a roast, a candle pour or a kiln load.

1. List the materials used, at what you paid: invoice price less trade discounts, plus freight in (26 CFR 1.471-3).
2. Add the direct labor for that piece or batch, including payroll taxes on helpers' pay, if your method counts labor. The materials-only method does not.
3. Add the production share of space, utilities and equipment, if your method counts them.
4. Divide by the number of units finished.

When you can match actual cost to a piece, use specific identification. When units of the same item are mixed and cannot be tied to invoices, use an assumption such as first-in first-out, which treats the oldest costs as sold first (Publication 538). For pricing you may want your own hours in a unit cost; for the return they stay out.

What about damaged items, samples, gifts and pieces you keep?

Pieces you keep, give away, damage or use as samples each leave inventory in a different way:

• Pieces you keep or give to family. Their cost comes out of purchases so it does not sit in cost of goods sold (Publication 334).
• Damaged or unsellable pieces. With a formal inventory, goods you cannot sell at normal prices because of damage, imperfections or a change of style may be valued below cost, and the burden of proof is yours, so a record of what happened to each piece matters (26 CFR 1.471-2). The 30-day rule and the proof are in writing off unsold or obsolete inventory.
• Gifts to charity. Charitable contributions are usually not business expenses (Publication 334). A piece whose cost was in opening inventory comes out of opening inventory, not cost of goods sold; one bought and given in the same year stays in cost of goods sold with no separate deduction. The deduction rules are in writing off unsold or obsolete inventory.
• Samples and business gifts. The deduction for business gifts is capped at $25 per person per year (Publication 463). Neither Publication 334 nor Publication 463 says how a gift or free sample of your own product is split between cost of goods sold and that cap. Record the cost, the quantity and who received it; the treatment is a judgment to settle with bookkeeping help before year end.

What makes a maker's cost of goods sold go wrong on a return, and when does it need a professional?

These are the usual errors:

• Unsold pieces valued at price. Profit is overstated by the markup on every unsold piece.
• Your own pay in the labor line. Line 37 is for others.
• Selling costs in cost of goods sold. Shipping, fees and marketing lower gross profit and distort any margin check.
• Stock or work in process left out of the count. Cost of goods sold is overstated by that amount.
• An opening figure that differs from last year's closing figure. Schedule C line 35 needs an attached explanation (Schedule C).
• Different treatment from year to year. Inventory practices must be consistent, and changing how you treat a material item generally means filing Form 3115 (Publication 538; Publication 334).

A gross profit far from what your pricing implies can mean sales, purchases, inventory or other costs were figured wrongly. The check is in the Schedule C cost of goods sold guide.

A case needs a professional's judgment when earlier returns showed no inventory, the opening figure does not match last year's close, records are missing, or the business is a partnership or corporation. Past returns that were wrong may need correcting, not just this year's figure.

Example

All figures are in US dollars and are illustrative.

A potter with a helper

An Ohio potter sells $40,000 of mugs. Clay, glaze and the retail boxes the mugs are sold in cost $6,000, and a helper who throws and glazes mugs is paid $4,000 in wages. With a formal inventory, all $10,000 is cost of goods sold; under the materials-only method only the $6,000 is, and the wages are an ordinary expense on another line. Her own time is not a cost either way. Her shipping labels, booth fees and marketplace fees are expenses on other lines. If she sold everything she made and held no stock at either end of the year, gross profit with a formal inventory is $30,000. Stock on hand at either end changes the figure.

A roaster with beans left at year end

An Oregon coffee roaster starts the year with $4,000 of beans at cost, buys and pays for $33,000 more and counts $5,000 at year end. Cost of goods sold for the beans is $32,000: $4,000 plus $33,000, less $5,000. Roasting labor and the share of rent for the roasting room are added or deducted separately, depending on her method.

A painter with unsold canvases

A painter has 12 finished canvases unsold at year end. They cost $1,500 in canvas, stretchers and paint, and she lists them at $12,000. Her ending inventory is $1,500. If she counted the $12,000 price, ending inventory would be too high by $10,500, cost of goods sold too low by the same amount and profit too high by $10,500. A canvas she hangs in her own home comes out of inventory. If earlier returns showed no inventory for canvases like these, those years may need correcting; see fixing inventory missing from past returns.

Different for you?

• Earlier returns showed no inventory, or this year's opening figure differs from last year's close: the earlier returns may need correcting. See fixing inventory missing from past returns, and get bookkeeping help to rebuild the count and cost.
• Your gross profit looks too high or too low, or you have added a helper, a second sales channel or wholesale: which costs belong above gross profit, and what your year-end stock is worth, are judgments to settle with bookkeeping help. For online sales, see bookkeeping for an online shop and online seller income tax.
• You have no purchase records or counts: see inventory and cost of goods without records, and get bookkeeping help to rebuild the figures.
• You are deciding whether to deduct materials when bought or hold them until sold: see materials and supplies or inventory. Changing the method generally means filing Form 3115, so settle it with bookkeeping help first.
• You sell at craft fairs or take commissions: see sales tax for craft fairs and handmade sellers.
• You are not sure the craft is a business: see business losses.
• Your business is a partnership or corporation, or an owner is paid for making the product: the return uses Form 1125-A, and whether owner pay belongs in cost of goods sold depends on the entity and how the owner is paid. See paying yourself and which returns your business files, and get bookkeeping help to settle it.