If you make or buy goods to sell, you can deduct the cost of goods sold from your gross receipts on Schedule C. However, to determine these costs, you must value your inventory at the beginning and end of each tax year.

This chapter applies to you if you are a manufacturer, wholesaler, or retailer or if you are engaged in any business that makes, buys, or sells goods to produce income. This chapter does not apply to a personal service business, such as the business of a doctor, lawyer, carpenter, or painter. However, if you work in a personal service business and also sell or charge for the materials and supplies normally used in your business, this chapter applies to you.

Figure your cost of goods sold by filling out lines 35 through 42 of Schedule C. These lines are reproduced below and are explained in the discussion that follows.

35	Inventory at beginning of year. If different from last year's closing inventory, attach explanation
36	Purchases less cost of items withdrawn for personal use
37	Cost of labor. Do not include any amounts paid to yourself
38	Materials and supplies
39	Other costs
40	Add lines 35 through 39
41	Inventory at end of year
42	Cost of goods sold. Subtract line 41 from line 40. Enter the result here and on page 1, line 4

If you are a merchant, beginning inventory is the cost of merchandise on hand at the beginning of the year that you will sell to customers. If you are a manufacturer or producer, it includes the total cost of raw materials, work in process, finished goods, and materials and supplies used in manufacturing the goods (see Inventories in chapter 2).

Opening inventory usually will be identical to the closing inventory of the year before. You must explain any difference in a schedule attached to your return.

If you contribute inventory (property that you sell in the course of your business), the amount you can claim as a contribution deduction is the smaller of its fair market value on the day you contributed it or its basis. The basis of donated inventory is any cost incurred for the inventory in an earlier year that you would otherwise include in your opening inventory for the year of the contribution. You must remove the amount of your contribution deduction from your opening inventory. It is not part of the cost of goods sold.

If the cost of donated inventory is not included in your opening inventory, the inventory's basis is zero and you cannot claim a charitable contribution deduction. Treat the inventory's cost as you would ordinarily treat it under your method of accounting. For example, include the purchase price of inventory bought and donated in the same year in the cost of goods sold for that year.

A special rule applies to certain donations of food inventory. See Food Inventory in Publication 526, Charitable Contributions.

You are a calendar year taxpayer who uses an accrual method of accounting. In 2010 you contributed property from inventory to a church. It had a fair market value of $600. The closing inventory at the end of 2009 properly included $400 of costs due to the acquisition of the property, and in 2009, you properly deducted $50 of administrative and other expenses attributable to the property as business expenses. The charitable contribution allowed for 2010 is $400 ($600 − $200). The $200 is the amount that would be ordinary income if you had sold the contributed inventory at fair market value on the date of the gift. The cost of goods sold you use in determining gross income for 2010 must not include the $400. You remove that amount from opening inventory for 2010.

If, in Example 1, you acquired the contributed property in 2010 at a cost of $400, you would include the $400 cost of the property in figuring the cost of goods sold for 2010 and deduct the $50 of administrative and other expenses attributable to the property for that year. You would not be allowed any charitable contribution deduction for the contributed property.

If you are a merchant, use the cost of all merchandise you bought for sale. If you are a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into a finished product.

The differences between the stated prices of articles and the actual prices you pay for them are called trade discounts. You must use the prices you pay (not the stated prices) in figuring your cost of purchases. Do not show the discount amount separately as an item in gross income.

An automobile dealer must record the cost of a car in inventory reduced by any manufacturer's rebate that represents a trade discount.

Cash discounts are amounts your suppliers let you deduct from your purchase invoices for prompt payments. There are two methods of accounting for cash discounts. You can either credit them to a separate discount account or deduct them from total purchases for the year. Whichever method you use, you must be consistent. If you want to change your method of figuring inventory cost, you must file Form 3115, Application for Change in Accounting Method. For more information, see Change in Accounting Method in chapter 2.

If you credit cash discounts to a separate account, you must include this credit balance in your business income at the end of the tax year. If you use this method, do not reduce your cost of goods sold by the cash discounts.

You must deduct all returns and allowances from your total purchases during the year.

If you withdraw merchandise for your personal or family use, you must exclude this cost from the total amount of merchandise you bought for sale. Do this by crediting the purchases or sales account with the cost of merchandise you withdraw for personal use. You must also charge the amount to your drawing account.

A drawing account is a separate account you should keep to record the business income you withdraw to pay for personal and family expenses. As stated above, you also use it to record withdrawals of merchandise for personal or family use. This account is also known as a "withdrawals account" or "personal account."

Labor costs are usually an element of cost of goods sold only in a manufacturing or mining business. Small merchandisers (wholesalers, retailers, etc.) usually do not have labor costs that can properly be charged to cost of goods sold. In a manufacturing business, labor costs properly allocable to the cost of goods sold include both the direct and indirect labor used in fabricating the raw material into a finished, saleable product.

Direct labor costs are the wages you pay to those employees who spend all their time working directly on the product being manufactured. They also include a part of the wages you pay to employees who work directly on the product part time if you can determine that part of their wages.

Indirect labor costs are the wages you pay to employees who perform a general factory function that does not have any immediate or direct connection with making the saleable product, but that is a necessary part of the manufacturing process.

Other labor costs not properly chargeable to the cost of goods sold can be deducted as selling or administrative expenses. Generally, the only kinds of labor costs properly chargeable to your cost of goods sold are the direct or indirect labor costs and certain other costs treated as overhead expenses properly charged to the manufacturing process, as discussed later under Line 39 Other Costs.

Materials and supplies, such as hardware and chemicals, used in manufacturing goods are charged to cost of goods sold. Those that are not used in the manufacturing process are treated as deferred charges. You deduct them as a business expense when you use them. Business expenses are discussed in chapter 8.

Examples of other costs incurred in a manufacturing or mining process that you charge to your cost of goods sold are as follows.

Containers and packages that are an integral part of the product manufactured are a part of your cost of goods sold. If they are not an integral part of the manufactured product, their costs are shipping or selling expenses.

Freight-in, express-in, and cartage-in on raw materials, supplies you use in production, and merchandise you purchase for sale are all part of cost of goods sold.

Overhead expenses include expenses such as rent, heat, light, power, insurance, depreciation, taxes, maintenance, labor, and supervision. The overhead expenses you have as direct and necessary expenses of the manufacturing operation are included in your cost of goods sold.

The total of lines 35 through 39 equals the cost of the goods available for sale during the year.

Subtract the value of your closing inventory (including, as appropriate, the allocable parts of the cost of raw materials and supplies, direct labor, and overhead expenses) from line 40. Inventory at the end of the year is also known as closing or ending inventory. Your ending inventory will usually become the beginning inventory of your next tax year.

When you subtract your closing inventory (inventory at the end of the year) from the cost of goods available for sale, the remainder is your cost of goods sold during the tax year.