Cost of goods sold is an expense account. Under Generally Accepted Accounting Principles, it appears on the income statement directly below revenue, carries a normal debit balance, and is treated as a temporary account that closes to retained earnings at the end of each period. It is not an asset, even though it draws its dollar value from the inventory asset account.
Where COGS Sits on the Income Statement
COGS has its own line on the income statement, separate from operating expenses such as rent, marketing, and administrative salaries. Revenue minus COGS equals gross profit, the first profitability measure lenders and investors look at. Operating expenses are then subtracted from gross profit to reach operating income. That layered structure lets a reader see whether the core product is profitable before overhead enters the picture.
The classification also matters for tax reporting. The IRS treats COGS as a deduction from gross receipts, so the figure directly reduces taxable income.1Internal Revenue Service. FS-2008-20 The Challenges of Business Income Overstating it shrinks taxable income and invites scrutiny; understating it means paying more tax than necessary.
Why COGS Is an Expense and Not an Asset
Inventory sitting on your shelves is an asset. Its cost is capitalized on the balance sheet because it still holds future economic value to the business. The moment those goods are sold, that value has been consumed to generate revenue, and accounting shifts the dollars off the balance sheet and onto the income statement. COGS is the account that receives them.
So the same dollar can start as inventory (asset) and become COGS (expense), but only one classification applies at a time. Unsold goods remain an asset. Sold goods become an expense in the period of the sale, matched against the revenue they produced.
How COGS Behaves in the General Ledger
COGS follows standard double-entry rules for an expense account. Under a perpetual inventory system, each sale triggers two entries at once: a debit to COGS (increasing the expense) and a credit to the inventory asset account (reducing the goods on hand). The revenue side is booked separately, with a debit to cash or accounts receivable and a credit to sales revenue.
Adjustments that reduce COGS, such as purchase returns or favorable inventory corrections, are recorded as credits to the account. That keeps the running balance aligned with the net cost of items actually sold.
A Temporary Account That Closes Each Year
Because COGS is an expense, it is a temporary account. Its balance resets to zero at the end of each accounting period. During the closing process, you transfer the balance into income summary by debiting income summary and crediting COGS. Income summary then flows into retained earnings, and COGS begins the next period at zero. That step isolates each period’s profitability and prevents expenses from one year from carrying into the next.
Shrinkage and Write-Downs Also Flow Through COGS
Not everything in the account comes from a sale. Theft, damage, spoilage, and counting errors create shrinkage, and under the matching principle those losses are recorded in the period they are discovered. They typically flow through COGS or a closely related shrinkage expense account. Separately, when inventory loses market value because of obsolescence, price drops, or damage, the lower-of-cost-or-market rule requires a write-down that increases COGS (or a loss account) in the period the decline is recognized.
What Costs Belong Inside the Account
Only costs directly tied to producing or acquiring the goods that were sold belong in COGS. IRS Publication 334 breaks these into specific categories reported on Schedule C for sole proprietors: beginning inventory, purchases, cost of labor, materials and supplies, and other direct costs.2Internal Revenue Service. 2025 Publication 334 – How To Figure Cost of Goods Sold In broader accounting terms, that generally means:
- Raw materials such as metal for manufacturing, fabric for clothing, or ingredients for food production.
- Direct labor paid to workers who physically assemble, produce, or process the goods. On Schedule C, this does not include the business owner’s own compensation.2Internal Revenue Service. 2025 Publication 334 – How To Figure Cost of Goods Sold
- Manufacturing overhead tied to the production environment, such as factory utility bills, equipment depreciation, and indirect materials.
- Freight-in, the cost of shipping raw materials or merchandise to your facility, which is added to inventory value and flows into COGS when the goods are sold.
Administrative salaries, marketing, office rent, and corporate legal fees do not belong in COGS. They are operating expenses, reported in a separate section of the income statement because they do not fluctuate with the number of units produced or sold. Keeping them out of COGS is what lets managers see production efficiency without the noise of general overhead.
Service Businesses and the Small Business Exemption
Businesses that sell services rather than physical products use a parallel expense concept often called cost of services or cost of revenue. It behaves the same way on the income statement, capturing the direct costs of delivering the service. IRS Publication 334 notes that pure personal-service businesses, such as doctors, lawyers, or painters, generally do not calculate COGS unless they also sell materials or supplies as part of their service.2Internal Revenue Service. 2025 Publication 334 – How To Figure Cost of Goods Sold
Some small businesses can also skip traditional inventory-based COGS accounting altogether. If your business has average annual gross receipts of $32 million or less over the three preceding tax years (the threshold for tax years beginning in 2026), you qualify as a small business taxpayer.3Internal Revenue Service. Revenue Procedure 2025-32 – Inflation Adjusted Items for 2026 Under Section 471(c), qualifying businesses can treat inventory as non-incidental materials and supplies, deducting the cost when the items are first used or consumed rather than tracking beginning and ending inventory balances.4Office of the Law Revision Counsel. 26 U.S. Code 471 – General Rule for Inventories
Where COGS Is Reported on Tax Returns
Where the account shows up on a return depends on the business structure. Sole proprietors report it in Part III of Schedule C (Form 1040), which walks through the calculation line by line: beginning inventory, purchases, labor, materials, other costs, and ending inventory.5Internal Revenue Service. Instructions for Schedule C (Form 1040) Corporations, S corporations, and partnerships that deduct COGS complete and attach Form 1125-A to their respective returns.6Internal Revenue Service. Form 1125-A Cost of Goods Sold In every case, the underlying account type is the same: an expense, matched against the revenue it helped produce, closed out at year end, and never carried on the balance sheet.