If you sell products, your books have a split that service businesses never think about: the cost of the things you sell lives in cost of goods sold (COGS), not in operating expenses. Getting this right isn't just tax compliance — it's the difference between knowing your margins and guessing.

Why the distinction exists

Suppose you buy candles for $6 and sell them for $15. The $6 isn't an expense of running the business the way rent is — it's the cost of the product itself. Separating the two gives you the most important line in retail accounting:

  • Revenue − COGS = gross profit (what your products earn before overhead)
  • Gross profit − operating expenses = net profit (what the business actually makes)

A shop with strong sales and weak net profit needs to know which lever is broken: thin product margins (a COGS problem — pricing, supplier costs, shrinkage) or heavy overhead (an opex problem — rent, software, payroll). Books that mix product costs into general expenses can't answer that question.

What belongs in COGS

COGS includes the costs of acquiring or producing the goods you sold:

  • The wholesale or manufacturing cost of merchandise
  • Raw materials and components, for makers
  • Freight-in — shipping and duties to get inventory to you
  • Packaging that's part of the product itself
  • Direct production labor, for manufacturers
  • Storage costs directly tied to holding inventory, in some cases

What stays in operating expenses: rent, utilities, marketing, software, insurance, professional fees — and, commonly confused, outbound shipping to customers, which is a selling expense, not COGS (though some sellers include it; pick a treatment and stay consistent).

The mechanics: inventory first, COGS when sold

Here's the part that surprises new retailers: buying inventory is not an expense. When you spend $5,000 on stock, you've traded cash for an asset — the inventory sits on your balance sheet at cost. The cost becomes COGS only when the goods sell. Buying a container of product in December doesn't reduce December's profit; selling it in March reduces March's.

The classic computation, done at least annually:

  1. Beginning inventory (at cost)
  2. Plus purchases during the period (including freight-in)
  3. Minus ending inventory (from a physical count or reliable tracking)
  4. Equals cost of goods sold

That physical count matters. Shrinkage — breakage, theft, lost items — shows up as inventory you don't have, which flows into COGS automatically through the formula. A count once a year is the minimum; quarterly is better if margins are tight.

What small businesses can simplify

Genuinely small businesses (under roughly $30 million in average annual receipts — indexed, and covering essentially every small retailer) are permitted to use simplified inventory methods: treating inventory as non-incidental materials and supplies, or following whatever their own books do. This is worth discussing with a tax professional, but two cautions apply.

First, "simplified" still doesn't mean "deduct when purchased" — even non-incidental materials and supplies are deducted when used or sold, not when bought. Second, even where a simpler tax treatment is available, keeping real inventory-and-COGS books is usually worth it anyway, because gross margin is how you run a product business. The tax shortcut doesn't tell you which product line loses money.

Practical setup for a small retailer

  • Record inventory purchases to the inventory asset account, with supplier and product noted.
  • Record COGS either per sale (if your point-of-sale or e-commerce platform tracks per-item cost) or as a periodic adjustment from the count formula above.
  • Do a physical count at year end, minimum. Investigate large gaps rather than shrugging them into COGS.
  • Watch gross margin monthly: COGS divided by revenue should be stable for a stable business. A creeping ratio means supplier price increases, discounting, or shrinkage — all worth catching in March rather than at year end.
  • Personal use of your own inventory isn't COGS — pull it out at cost as a draw.

The habit that matters most: never let product costs leak into general expense categories. One clean COGS line makes every pricing and purchasing decision better informed.