Cost of Goods Sold (COGS)
The Cost of Goods Sold equation that all product-based businesses must use for calculating net income, was originally used (prior to 1913) for aiding business owners in seeing the basic profitability of the products they sold during the course of a year. However, when used in tax accounting, it becomes a simple yet deadly equation, even taxing inventory that has not yet been sold.
While this statement may seem outlandish at first glance, consider the following: The COGS equation is: (Beginning Inventory + Inventory Purchases) – Ending Inventory = COGS. Nothing mathematically wrong with that. However, if the business has more Ending Inventory than Beginning Inventory, they get taxed on the value of increased inventory at full income tax rates. Keep in mind that the business hasn’t even sold this excess inventory nor made any money from it. To the business, it’s an expense, not income. And when the inventory is eventually sold the following year, income tax is due again on the profits… effectively a double tax.
As an example of the negative impact of this, look at 2008. The year was cranking along economically, so businesses stocked up on inventory in anticipation of a booming 3rd and especially 4th quarter. (Financial industry people knew better, but the average merchant had no idea what was coming.) Then everything hit the fan in the latter half of September with the stock market crash and everyone stopped buying just about everything, leaving businesses with massive inventories at the end of the year which they then had to pay income tax on. Why so many lay-offs and businesses going under in 2009/10? Between the credit crisis and this tax penalty on increased inventories, even normally healthy businesses could barely survive. Many did not.
Take a look at the following spreadsheet. Read the notes and then look at the numbers to see a basic example of the punitive nature of COGS and how expensed inventory works with cash flow in a fair way. (This is best viewed on a computer, not your phone.)
In summary, the problem with current COGS accounting rules is that inventory-based businesses are effectively taxed on excess inventory at the end of the year. This is especially painful for first year startups, as their beginning inventory is typically zero, and their cash flow is being robbed by the IRS just when they're starting to get off the ground. The inventory is an expense to the business owners, but the IRS effectively considers it income. This causes businesses to hold back ordering more inventory for Q4 which can lead to shortages in that normally strong sales quarter. It can also lead to businesses dumping excess inventory at the end of the year by slashing prices and cutting their profit margins. A very unstable business cycle results either way.
Drawing from my own company’s experience over the past 10 years, here’s how the COGS tax penalty played out:
So that's how COGS can hurt a very small business. Let's see how bad it can get by looking at a very large business. Here is the COGS penalty that Wal-Mart has had to endure:
That's nearly $4 Billion dollars in additional income taxes Wal-Mart has paid over the past ten years, simply for the privilege of growing their business. This was income tax paid not on income, but on unsold inventory. And then they had to pay income tax again, once the inventory was sold the next year.
OK, getting back to figures that mere mortals can relate to...
I have another personal example of how COGS hurt my primary business in December, 2010. At the end of that month, our Ending Inventory wound up being $164,562 higher than our Beginning Inventory. Our business had grown a lot in 2010 and we didn’t want to get caught being out of stock of our best-selling products at year end as happened the previous year. In order to grow with product demand, we had to stock up as compared to the prior year. However, we ended up paying the IRS over $57,000 ($164,562 x 35%) for the privilege of increasing inventory and growing the business. And that $57,000 was not tax on profits; it was strictly a tax on inventory sitting in our warehouse. Because of this, we nearly cancelled construction we were planning for our warehouse space to add second floor offices and a showroom. The cost of the build-out was about $100,000. If we had cancelled the project, the contractors who were hoping to get a nice boost to their business in what is normally a slow month would not have gotten it. The suppliers of building materials would not have gotten a boost either, and on down the line. The project did get delayed a bit, but it was completed by May of 2011. Of course, with 39-year depreciation, we ended up paying income tax for 2011 on most of that $100,000 as well.