One of the most common accounting mistakes that business owners make is failing to understand what type of taxpayer they are. You’ve probably heard that there are two different ways to calculate your income: cash-basis or accrual-basis. Cash means if you receive cash, you have taxable income. If you are waiting to get paid (Accounts Receivable), then you don’t have taxable income yet. On the other hand, accrual-basis means that Accounts Receivable is taxable just as if you received income. Accounts Payable is deductible just as if you’d written a check.
But, it’s not quite that simple. There is another type of taxpayer – hybrid. Hybrid means that you’re cash basis, except for the recordation of inventory. Inventory is not a deduction for your business. But cost of goods is.
Here’s an excerpt from Understanding Financial Statements Fundamentals that explains a little more about that:
The Biggest Reason Cash Doesn’t Equal Income
Sonja was excited with the growth of her business. But she also knew she wouldn’t have to pay much in taxes because there wasn’t much in the bank account. She’d never taken out profit or a salary. So because it had all gone into her business, she was home free!
Sonja had built up her inventory to get ready for the sales that were coming and although they used up her cash, they weren’t an expense to the company. She had converted one asset (cash) to another asset (inventory) and Sonja had to suddenly worry about how she was going to pay her tax bill.
How to Calculate COGS (Cost of Goods Sold) for Your Business Inventory
With inventory, it’s critical that you know the cost where you start and the cost where the year ends. Your inventory value may go up and down during the year, but those two costs are key. You can’t calculate your COGS without knowing those two numbers.
The formula for COGS is:
COGS = Beginning Inventory + Purchases – Ending Inventory
Your COGS amount is important, because it hits your financial records. If you underestimate your COGS, your inventory looks like it’s worth more on paper. But if you overestimate it, your inventory becomes undervalued. Neither is particularly good, because they don’t show you a true, accurate picture of your business’s value.
You may also have COGS without an inventory. For example, let’s say you have a service business. You hire others (a COGS of your business) which is an expense against the money you make. No inventory here! But there is still a COGS.
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