# 'Splain to me inventory and COGS

I’m a newbie artist trying to do my taxes, and even though I’m a fairly intelligent human being, I am having a very difficult time understanding the concepts of inventory and cost of goods sold (COGS).

One source I found says “Value of inventory at the beginning of the year” - “Value of inventory at the end of the year” = COGS

My confusion, I think, is how one determines inventory. Here’s the situation:

I have a boatload of beads, most of which are seed beads and, as with a painter, it isn’t really feasible to determine how many seed beads are used in a particular piece. I have records of how much I spent in 2008 on seed beads, though.

I have other supplies, like ear wires, that I can associate with a particular piece – e.g., I made 20 pairs of earrings with sterling silver ear wires. I have records of total amount spent on findings.

Then I have an inventory of finished pieces that I produced and sold during the year, and pieces that I didn’t sell before the end of the year.

How do I use the above information to determine the value of my inventory at the beginning and end of the year? One source I read leads me to believe the seed beads, since they can’t be associated with a particular finished piece, should be listed as “Supplies” rather than included in the inventory cost.

Any help anyone can provide would be greatly appreciated. Or is there an “Taxes for Dummy Artists” book out there that I should get?

COGS=Beginning Inventory-Ending Inventory+Cost of Goods Manufactured

Only the beads which have been converted into finished goods would be included in COGMF.

Hey, I only took 2 semesters of Accounting, but I did get an A

If you were a retailer, your inventory on date X would be the value of the goods you hold out for sale on date X, at the lesser of their cost or fair market value.

Thus on Jan 1, you have 100 Model 1 Widgets which you bought for 44 cents each and retail at \$1.00. Your Model 1 Widget inventory value is \$44.00.

Also on Jan 1, you have 100 Model 2 Widgets which you bought for 32 cents. Model 2 Widgets are now seriously out of fashion and you are clearancing them at 25 cents each. Your inventory value for Model 2 Widgets is \$25.00.

COGS is an expense account which reflects that sales revenue has to be reduced by, wait for it, the Cost of Goods Sold to get to profit/loss.

So COGS = Sum of cost of individual items sold. Your inventory value typically tracks cost. So how much have you sold over a given period? Ending inventory - Beginning Inventory + Wholesale Purchases

As a fabricator, your system is a little more complicated than this, but it doesn’t really differ in principal. Essentially, you have a few more inventory accounts: raw materials, works-in-progress, and finished goods. The division between direct and indirect materials will reflect your ability to associate particular units of raw material with a finished product. (Beads will be indirect material, since you cannot track it well; ear wires will be direct material.)

These links might help:

Costing Terminology

The Cost of Goods Manufactured Schedule

Accounting by Manufacturing Companies

You guys are making this too complicated for a case like this. There’s no reason to use lower of cost or market or proper accounting methods for a small manufacturer for tax purposes.

Let’s say beads are \$10 per pound. You go out to the shop and weigh the beads you have on hand. 12 pounds, so you’ve got \$120 in ending inventory. You look at your invoices and see that you bought \$800 in beads. Now, you may or may not have a number for your beginning inventory, but you’ve established the approximate value of the ending inventory. Was that more or less than the beginning amount? Let’s say you think you’ve got half of what you had before. So you started with \$240.

\$240+\$800-\$120 = \$920 COGS in beads either sold or made into a product.

Repeat this process for wire and any other inventory items.

Now, count up any finished items on hand. Estimate the cost of materials that went into them. I know you don’t have exact numbers, but you should be able to estimate whether it was 20 beads or 50 in each item. You’ve got now got your ending inventory value for finished items. Determine your beginning value and subtract. This gives you the change in finished inventory and you can add that to the COGS you calculated for each supply.

The IRS doesn’t care, but most accountants will want to talk about supplies (raw materials), work in process and finished goods inventories. Unless you’re dealing in millions of dollars, don’t worry about that. If you are dealing in millions of dollars, inventory is only one of many things you need a CPA for. (I’d recommend finding a good CPA or EA who understands small business anyway).

Your biggest problem at this point is that it’s April 1 and you can’t do a count for Dec 31. Thus, you have even more estimating to do.

I am also afraid to ask this for fear of creating confusion (IANA) but isn’t direct labor also included in COGS, in addition to raw materials?

Obviously, I don’t know this for sure since I’m the OP, but on Schedule C under “Cost of labor,” it says “Do not include any amounts paid to yourself.” I’m the artist, so the only labor in question here is my own. I don’t pay anyone else to do anything. So I’m assuming I don’t have any direct labor costs.

COGS is tied to the valuation of inventory since COGS = beginning inventory - ending inventory + net purchases. The valuations of the beginning and ending inventories are not straighforward because inventory units can vary in costs. This leads to a discussion of topics like LIFO, FIFO, and average costs. Inventory valuation also can differ from one industry to another. One of the objectives in choosing a method of inventory valuation is to lessen the tax burden. A company whose inventory tends to rise in value (like drugs) will not necessarily use the same method as a company whose inventory tends to fall in price (like computer parts). So this is not a trivial subject.

Both of you are right. COGS does typically include direct labor (and, for larger companies, an allocation of overhead labor). But you do not include time spent by a sole proprietor as a cost anywhere on a Sch C.

It is my fondest hope that I develop such a following that I’ll have to worry about the fact that, at the end of the year, my jewelry is worth more than it was at the beginning of the year.

Unfortunately the “valuation” is what YOU paid, not what you sell the items for. COGS is all about what it cost you to make the items you sold.

I’ll take a crack at this COGS. I’m going to try to come up with the simplest example I can to explain.

Let’s say you make widgets. And to make a widget it takes a certain amount of "A"s and a certain amount of "B"s. Each widget may vary somewhat in the mix of As and Bs. And you buy the As and Bs in bulk to save money.

• At the beginning of the year, say you had 50 widgets left over from last year.

• During the year, you built 300 widgets.

• And at the end of the year, you found you had 100 widgets left.

So the first step is to determine how many widgets you sold.
Which you can figure out by:
starting inventory (50) + widgets you built (300) - widgets left at the end (100) = 250 sold

So now we need to figure out what it cost you to build those 250 units: the “cost of goods sold”

If you could easily determine the mix of A’s and B’s that were used on each unit, you would then count up how many A’s and how many B’s were used to build those 250 units.
But if this is not practical (like if A is a paint, for example), you can estimate how much is used in
each unit. Since the mix of As and Bs can vary from widget to widget, the easiest would be to determine the average number of As and Bs each unit requires. If, for 100 widgets, you used 275 As and 40 Bs, then you could say that each widget uses 2.75 (275/100) A’s and .4 Bs (40/100).

So now you can estimate that those 250 widgets required 250 X 2.75 = 687.5 A’s and 250 X .4 = 100 B’s to build.

If the cost (how much it cost you to buy) of A’s is \$.02 each, and the cost of B’s is \$1.25 each,
we can compute the COGS as:
( 687.5 X .02 ) + ( 100 X 1.25 ) = 138.75 Now where it gets tricky is if the cost of A's and B's changes over the time. That is, if you paid, say .015 per A last year, and this year an A costs \$.02 each. This is where the LIFO, FIFO and other schemes comes into play. But we won’t get into that at this time.

Does this make sense ?

Yes, it does, and thanks to you and** dracoi,** what I ended up doing was figuring out an average cost per gram of beads (which wasn’t too difficult, since I don’t use precious metal beads), and I am now in the process of weighing items w/o findings to determine how many grams of beads go into a typical pair of earrings, a typical bracelet, etc.

The only thing I use that might fluctuate more than a few cents in value is sterling silver and gold-filled findings. Fortunately, I’m buying them in small enough quantities to know that ten pairs of earrings in inventory have sterling earwires from Vendor A @ \$1.12 a pair, and 15 pairs have sterling earwires from Vendor B @ \$1.09 a pair.

I run a small business in the used book trade, but my volume is well under \$1M annual.
I use COGS, but I keep seeing articles that claim businesses with “under \$1M gross” don’t have to do accrual accounting.
Are the articles full of it?