Generally speaking, the Internal Revenue Service (IRS) allows companies to deduct the cost of goods that are used to either make or purchase the products they sell for their business. For accounting and tax purposes, these are listed under the entry line item cost of goods sold (COGS).
This deduction can be a major benefit to companies in the manufacturing or mining sectors that have capital-intensive, lengthy production processes and COGS figures that can be quite high. However, not all businesses can claim a COGS deduction, because not all businesses can list COGS on their income statement.
Exclusions From Cost of Goods Sold Deduction
Many service companies do not have any cost of goods sold at all. COGS is not addressed in any detail in generally accepted accounting principles (GAAP), but COGS is defined as only the cost of inventory items sold during a given period. Not only do service companies have no goods to sell, but purely service companies also do not have inventories. If COGS is not listed on the income statement, no deduction can be applied for those costs.
Examples of pure service companies include accounting firms, law offices, real estate appraisers, business consultants, professional dancers, etc. Even though all of these industries have business expenses and normally spend money to provide their services, they do not list COGS. Instead, they have what is called "cost of services," which does not count towards a COGS deduction.
Cost of Revenue Versus COGS
There are also costs of revenue for ongoing contract services that can even include raw materials, direct labor, shipping costs, and commissions paid to sales employees. Even these cannot be claimed as COGS without a physically produced product to sell, however. The IRS website even lists some examples of "personal service businesses" that do not calculate COGS on their income statements. These include doctors, lawyers, carpenters, and painters.
Many service-based companies have some products to sell. For example, airlines and hotels are primarily providers of services such as transport and lodging, respectively, yet they both sell gifts, food, beverages, and other items. These items are definitely considered goods, and these companies certainly have inventories of such goods. Both of these industries can list COGS on their income statements and claim them for tax purposes.
COGS and Other Deductions
Costs of goods sold include the direct cost of producing a good or the wholesale price of goods resold. Other potentially deductible costs include labor, assuming the labor was directly involved in the good's production process, supplies, shipping costs, freight in, and directly related overhead.
There are also some indirect costs that can be included in COGS. Indirect costs can include rent, taxes, storage, handling, repacking, and certain administrative costs.
Companies that can claim COGS do so on their Schedule C via line 42. This is only possible if the company accurately values its inventory at the beginning and end of each tax year. If an expense is included in COGS it can’t be counted again as a business expense.