The popularity of online markets such as eBay and Etsy has been accompanied by 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 any other retailers, including listings of cost of goods sold, or COGS, on their income statements.
Cost of goods sold is the accounting term used to describe the expenses incurred, either creating or obtaining goods for sale. These are direct costs only, and only businesses with a saleable product can list COGS on their income statement. Used to determine sales revenue for the tax year and potential profit, the most common way to calculate COGS is to take the beginning annual inventory amount, add all amounts of goods purchased, and then subtract the year ending inventory from that total.
Examples of what can be listed include the cost of materials, purchase price of goods to be resold and even distribution costs. "Goods" include any items purchased with the intent to resell, and materials and supplies used to manufacture a product. Items that have been purchased but returned or used for personal use cannot be included in this amount. Any business supplies not used for directly or indirectly manufacturing a product are deducted separately from COGS. Manufacturing and mining businesses can include the cost of direct and indirect labor; containers excluded from general shipping and selling expenses; freight-in supplies and merchandise; and any direct or indirect overhead expenses that keep the manufacturing operation running, such as rent, maintenance, and supervision.
COGS and Online Retailers
Online businesses that operate through Etsy or eBay can claim most of these same costs. For example, a business that builds and sells a widget through 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 is not COGS.
The Internal Revenue Service, or 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 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.