Cost of Goods Sold: How to Calculate It on Schedule C
Cost of goods sold (COGS) is the direct cost of the products you sold during the year: the goods themselves if you resell, the raw materials and parts if you make them, and the wages paid to the people who make them. It is not everything you spent. On a Schedule C, the IRS subtracts cost of goods sold from your sales to get gross profit, so COGS is the number that sits between the two. This guide runs one small business's year through the return, line by line, so you can see exactly what belongs in it.
What cost of goods sold means
Cost of goods sold answers one question: of everything you sold this year, what did those specific items cost you? A store that buys mugs for $4 and sells them for $10 has a cost of goods sold of $4 per mug sold. A candle maker's COGS is the wax, wicks, and jars that went into the candles that left the shelf.
The IRS puts it plainly in Publication 334, its tax guide for small businesses: if you make or buy goods to sell, you value your inventory at the start and end of each year to determine your cost of goods sold, and COGS is deducted from gross receipts to figure gross profit. On the Schedule C, gross receipts on line 1 (less any returns) minus cost of goods sold on line 4 equals gross profit on line 5. Get COGS wrong and every profit figure below it is wrong too.
The word "sold" is the part people miss. Cost of goods sold counts the cost of what left your inventory, not what you bought. Buy 1,000 mugs, sell 600, and only those 600 are COGS this year; the other 400 stay in inventory and become COGS in the year they sell.
What goes into COGS, and what stays out
Schedule C Part III breaks cost of goods sold into five inputs. The IRS instructions label them on lines 35 through 39:
| Schedule C line | What it holds |
|---|---|
| Line 35: Inventory at beginning of year | The value of unsold goods you carried in from last year |
| Line 36: Purchases less cost of items withdrawn for personal use | Goods and raw materials you bought to sell or use in production |
| Line 37: Cost of labor | Wages paid to people who make the product (not your own draw) |
| Line 38: Materials and supplies | Physical inputs that go into what you sell |
| Line 39: Other costs | Freight-in, containers, and factory overhead tied to production |
Everything else is an operating expense, and it belongs in Part II of the Schedule C, below the gross-profit line. Rent, advertising, accounting software, and your phone bill are the costs of running the business, not the cost of the goods themselves. The distinction is not cosmetic: put an operating cost into COGS and you understate gross profit; put a product cost into operating expenses and you overstate it.
| Belongs in COGS (Part III) | Belongs in operating expenses (Part II) |
|---|---|
| Wax, wicks, and jars for the candles | Rent on the workshop (line 20b) |
| Wholesale goods bought to resell | Advertising and listing fees (line 8) |
| Freight-in to receive your inventory | Shipping a sold order to the customer |
| Wages of the person who pours candles | Accounting software and your phone |
Two boundaries trip people up. The first is your own labor: a sole proprietor cannot pay themselves a wage, so the owner's own time stays off the return entirely. The second is shipping. The cost to get inventory to you, called freight-in, is part of COGS on line 39. The cost to ship a sold order out to the buyer is a selling expense in Part II. Same trucks, opposite direction, different lines.
The cost of goods sold formula
Part III is just a formula written as tax lines. Add the five inputs, then subtract what is still on the shelf at year-end:
Beginning inventory + purchases + cost of labor + materials and supplies + other costs − ending inventory = cost of goods sold.
On the form, lines 35 through 39 add up on line 40, and line 41 (inventory at end of year) is subtracted to give line 42, the cost of goods sold. Line 42 then carries up to line 4.
A pure reseller who buys finished goods and adds no labor or materials uses the short version: beginning inventory + purchases − ending inventory. With $5,000 of goods on hand January 1, $40,000 of purchases during the year, and $7,000 left December 31, cost of goods sold is $5,000 + $40,000 − $7,000 = $38,000.
One business's year, mapped to Schedule C Part III
Take Priya, who makes and sells candles as a sole proprietor. She carried $8,000 of finished candles and raw wax into the year, bought more wax and jars, paid a part-time helper to pour, and had $11,000 of unsold stock at year-end. Here is her Part III.
| Cost of goods sold input | Schedule C line | Amount |
|---|---|---|
| Inventory at beginning of year | Line 35 | $8,000 |
| Purchases (less personal use) | Line 36 | $22,000 |
| Cost of labor (part-time pourer) | Line 37 | $6,000 |
| Materials and supplies (wax, wicks, jars) | Line 38 | $9,000 |
| Other costs (freight-in, boxes) | Line 39 | $2,000 |
| Subtotal | Line 40 | $47,000 |
| Less: inventory at end of year | Line 41 | ($11,000) |
| Cost of goods sold | Line 42 → Line 4 | $36,000 |
The $47,000 on line 40 is everything Priya put into inventory this year plus what she carried in. But she did not sell all of it. The $11,000 still on the shelf on December 31 is not a cost of anything sold yet, so it comes back out on line 41. What remains, $36,000, is the cost of the candles that left the shelf. That figure flows to line 4, and her gross profit falls out of it:
| Income statement step | Schedule C line | Amount |
|---|---|---|
| Gross receipts (sales) | Line 1 | $90,000 |
| Less: cost of goods sold | Line 4 | ($36,000) |
| Gross profit | Line 5 | $54,000 |
Sales of $90,000 minus COGS of $36,000 leaves a gross profit of $54,000, a 60% gross margin. Every operating cost, from workshop rent to Etsy fees, still has to come out below that line before Priya reaches net profit. Those are the expenses you track in Part II, and they are a separate exercise from COGS.
Do you even have cost of goods sold?
Plenty of businesses do not. If you sell your time rather than a product, a consultant, a designer, a coach, you usually have no inventory and no cost of goods sold at all. Every cost you incur is an operating expense in Part II, and Part III stays blank. The glossary articles that rank for "cost of goods sold" rarely say this, and it sends service freelancers hunting for a number they do not owe.
Even businesses that do sell goods get a break if they are small. Internal Revenue Code section 471(c) lets a small business taxpayer, one whose average annual gross receipts for the prior three years are at or under $32 million for 2026 (Revenue Procedure 2025-32 sets the inflation-adjusted figure), treat inventory as non-incidental materials and supplies instead of running full inventory accounting. In plain terms, most one-person product businesses can follow the way they keep their own books rather than the elaborate method a large manufacturer must use. The purchase and materials receipts still matter; the paperwork around them gets lighter.
Common misconceptions about COGS
"Cost of goods sold is everything I spent." No. It is only the direct cost of the goods you sold. Rent, advertising, and software are real deductions, but they live in Part II as operating expenses, below the gross-profit line, and they stay out of cost of goods sold. Mixing them in inflates COGS and hides how the product is really performing.
"I deduct inventory the moment I buy it." Not under inventory accounting. A purchase becomes cost of goods sold in the year the item sells. Until then it sits in ending inventory on line 41 and carries into next year. Buy a $10,000 pallet in December and sell none of it, and your COGS from that pallet this year is zero.
"Cost of goods sold and operating expenses are the same deduction." They both reduce your taxable profit, but they answer different questions and sit on different parts of the return. COGS (Part III) tells you whether your product makes money. Operating expenses (Part II) tell you what it costs to run the business around it. Keeping them apart is what makes a chart of accounts useful.
Frequently asked questions
What is the cost of goods sold formula? Beginning inventory + purchases + cost of labor + materials and supplies + other costs − ending inventory. A reseller with no labor or materials uses the short form: beginning inventory + purchases − ending inventory.
Where does cost of goods sold go on my tax return? On Schedule C, you compute it in Part III on lines 35 through 42, then carry line 42 up to line 4. Line 1 (gross receipts) minus line 4 gives gross profit on line 5.
Do I include shipping in cost of goods sold? Freight-in, the cost to receive your inventory, is part of COGS on line 39. Freight-out, the cost to ship a sold order to your customer, is a selling expense in Part II, not COGS.
Does a service business have cost of goods sold? Usually not. A business that sells its time and holds no inventory reports all its costs as Part II operating expenses and leaves Part III blank. A service business that also uses physical parts, like a plumber installing fixtures, can have a cost for those materials.
Can I deduct inventory I bought but have not sold? Not as cost of goods sold. Unsold goods stay in ending inventory and become COGS in the year they sell. Small business taxpayers under the $32 million gross-receipts test have more flexibility on the timing under section 471(c).
Key takeaways
- Cost of goods sold is the direct cost of the goods you sold, not everything you spent. On Schedule C it is line 42, carried to line 4, and gross receipts minus COGS equals gross profit on line 5.
- The formula is beginning inventory + purchases + cost of labor + materials and supplies + other costs − ending inventory. Resellers use the short form without labor or materials.
- Only direct product costs count. Rent, advertising, and software are Part II operating expenses; freight-in is COGS but freight-out is a selling expense.
- A purchase becomes COGS when the item sells, not when you buy it. Unsold stock sits in ending inventory and carries to next year.
- Many businesses have no COGS at all. Pure service businesses leave Part III blank, and small business taxpayers under $32 million in gross receipts can treat inventory as materials and supplies under section 471(c).
Every number on Priya's Part III started as a supplier invoice or a purchase receipt. Capture and categorize those as they arrive and the inputs to cost of goods sold are ready when the return is due, not reconstructed in April. Get Started with SparkReceipt to keep the receipts behind your COGS in one place, whether you scan them at the counter or forward them from your inbox. It fits ecommerce sellers tracking COGS especially well.