The popularity of online markets such as eBay and Etsy has resulted in an expansion of businesses that transact through these markets. Some businesses operate exclusively through online retail, taking advantage of a worldwide target market and low operating expenses. Though non-traditional, these businesses are still required to pay taxes and prepare financial documents like any other company. They should also account for their inventories and take advantage of tax deductions like other retailers, including listings of cost of goods sold (COGS) on their income statement.

Cost of Goods Sold (COGS)

Cost of goods sold is the accounting term used to describe the expenses incurred to produce the goods or services sold by a company. These are direct costs only, and only businesses with a product or service to sell can list COGS on their income statement. When subtracted from revenue, COGS helps determine a company's gross profit. The most common way to calculate COGS is to take the beginning annual inventory amount, add all purchases, and then subtract the year ending inventory from that total.

Examples of what can be listed as COGS include the cost of materials, labor, the wholesale price of goods that are resold, such as in grocery stores, overhead, and storage. Any business supplies not used directly for manufacturing a product are not included in COGS.

Cost of Goods Sold (COGS) and Online Retailers

Though operating differently than traditional retail companies, online businesses can claim most of these same costs. For example, a business that builds and sells a widget through eBay (EBAY) may list any raw materials used to create the widget as a COGS. When those raw materials are shipped to the place of business, even a home, the shipping costs count towards COGS.

If a business has no real costs of production and only engages in the purchasing and reselling of goods over the internet, it may still list the amount spent on purchases as COGS. Packaging may even be included, but only so long as the packaging is unique and resembles what would appear on a shelf in a physical location. The bubble wrap, tape, and cardboard used to deliver the widget to a customer are not COGS. The cost of shipping to the customer is also not included in COGS.

The Internal Revenue Service (IRS) allows companies to deduct the COGS for any products they either manufacture themselves or purchase with the intent to resell. This deduction is available to any business that lists COGS on its income statement, including manufacturers, wholesalers, and retailers – whether they operate in physical locations or only online. 

Take, for example, a retail business that operates through Etsy (ETSY) and has less than $1 million in annual sales. It keeps track of inventory, such as unused materials, unsold goods, etc. Under these circumstances, IRS Publication 334: Tax Guide for Small Business, details how the business can use the cash method of accounting to deduct inventory expenses. If supplies are imported for the Etsy seller, then any taxes, commissions, duties, or other associated fees may count as COGS for IRS purposes. However, fees associated with online services such as PayPal may not be counted towards COGS. Additionally, the time spent marketing goods online does not count towards COGS.

The Bottom Line

Cost of goods sold (COGS) is an important line item on an income statement. It reflects the cost of producing a good or service for sale to a customer. The IRS allows for COGS to be included in tax returns and can reduce your business's taxable income. Whether you are a traditional retailer or an online retailer, the same rules apply.