If your business makes, handles, or sells physical products, your cost of goods sold (COGS) is one of the most powerful tools you have for reducing taxable income. Because costs of sales directly offset your revenue, what you can legitimately include in that line item matters. And most businesses are leaving money on the table.
Typically, expenses like rent, utilities, and non-direct labor cannot be included in COGS. Unless you’re using proper cost accounting. Here’s how it works.
Section 471 is a little-known tax code section with a big impact on product-based businesses. It was originally written to describe how manufacturers can properly allocate a portion of their operating costs, like fixed overhead, to the cost of sales.
Some legwork is required, though. To take advantage of it, your business needs to:
We recommend working with your accountant to get those foundations in place. Once your business follows these accounting methodologies, expenses typically treated as pure operating costs, like rent, may be partially allocated to cost of sales through accurate inventory costing.
A cost study is the documentation that makes your allocations defensible. It’s a cornerstone of strategic tax planning for any business that carries inventory.
One method we recommend: track your employees’ time for 90+ days to get a reliable average of where their hours actually go. This is especially valuable for retail and production businesses where wages are split between selling and getting products ready for sale.
Say your team spends a third of their time assembling, packaging, labeling, and prepping products for sale. A well-documented cost study could allow you to allocate a portion of cost of sales to wages, payroll taxes, employee benefits expenses, and more… meaning lower tax liability backed by documentation.
These strategies only work when they’re employed alongside the required accounting regulations. In other words, we strongly recommend working with small business accountants who have experience with:
Getting this wrong can create more problems than it solves. Getting it right can meaningfully change what you owe.
Not sure where to start? We can help. Cultivate is the only CPA firm in New England that combines business tax consulting and small business accounting services with an inventory costing and valuation specialist.
Contact us today to find out what a cost study could do for your bottom line.
Christine Gervais
Christine Gervais is a licensed CPA, using her skills to help businesses grow and achieve their fullest potential. Christine has a Master’s degree in accounting from Southern New Hampshire University in addition to holding her CPA license for over a decade. Notably, Christine is a nationally recognized speaker providing education to other CPAs on how to best serve clients as well as instruction on a wide variety of topics for business owners on how to maximize success. Christine prides herself on the value she can bring to clients with her extensive tax knowledge and provides strategic, forward-thinking financial strategies to help clients grow. When not behind her desk, you can find Christine spending quality time with her daughter and stepson or tending to the family’s excessively loved farm animals.
