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    COGS and Cost of Labor
    Background: We are an S-Corp. We manufacture games and sell them on our website. (We also purchase some inventory to sell.) For the products we make, when I calculate my inventory, I don't include the cost of labor. IRS cost of goods sold has cost of labor as a separate line item. For 2012, I decided not to include anything on this line because I figured labor could be deducted outside of the COGS calculation.

    We have four employees. Two are dedicated to making parts, one is a admin and one is mixed. So if I did include the cost of labor, I would have to determine how much labor went into making these parts. Probably around 2.5 employees worth.

    The Question: Am I ok with not including labor in my COGS calculation even though most of my inventory has significant labor in them? I figure that labor will be deducted on line 8 of form 1120S.

    More info/thoughts: My old CPA told me not to include labor so now I feel like I would invalidate previous year inventories if I change. I think it makes sense to include labor in the inventory costs so that it rolls over into the next year with the proper costs. The only real issue is if we have a huge increase in inventory at the end of 2013, it could skew our deductions because we will be deducting all the labor in 2013 as opposed to rolling some over to 2014. Correct?


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    If you pay for the labor used in making the product then you should add it [the cost of labor] to your COGS because you'll have to deduct the payments you make to your employees when calculating your net profit. According to tax experts, the following should be included in Cost of Goods Sold:

    Cost of parts used to make a product.
    Cost of raw materials.
    All direct costs: labor, rent, etc.
    Indirect costs, if any.


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    There are some exceptions for small companies, but if you are required to report inventory and cost of goods sold, you must include all costs.

    The failure to include all costs in your inventory / cost of goods sold will make your income incorrect. That is because the cost of a product (the "cost of goods sold") is not deducted until you sell that product. This happens because the cost of products you have not yet sold is reported as inventory. Therefore, if you deduct labor as a general expenses when some should be included in your ending inventory of un-sold products, than those costs were deducted in the wrong year.

    For example, you have $1,000 of labor costs in 2012 to produce 1,000 units of your product, $1 per unit. If you only sold 700 units, your ending inventory should include the $300 labor cost of those 300 units that were not sold. If you don't do this and deduct that labor in 2012, you have underreported your income for 2012 by $300 because you deducted $300 too much of labor costs.


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    mkp007

    It is possible that you might be guilty of bad form. But bad form in this case will not get you a disallowed deduction. One of the most important things with accounting and tax for businesses is to be consistent so that things are comparable from one year to the next.

    Jeff


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