Cost of Goods Sold: Inventory Accounting Methods and How COGS Affects Your Business Taxes
Cost of goods sold isn’t just an accounting concept; it’s a tax deduction that directly reduces taxable income. Under IRC 263A (the Uniform Capitalization, or UNICAP, rules), businesses that produce or resell merchandise must capitalize certain costs into inventory rather than deducting them as current expenses. The costs remain in inventory (on the balance sheet, not the income statement) until the inventory is sold, at which point the capitalized costs flow into COGS and reduce taxable income. For small businesses with average annual gross receipts of $32 million or less (the TCJA small business taxpayer exception, 2026 figure), the UNICAP rules don’t apply, and the business can use a simplified method that treats inventory as non-incidental materials and supplies, deducting the cost when the items are sold or consumed. The choice of inventory valuation method (FIFO, LIFO, weighted average, specific identification) has a direct impact on the timing and amount of the COGS deduction, and changing methods requires filing Form 3115 (Application for Change in Accounting Method) with the IRS.
Inventory valuation methods:
| Method | How It Works | Effect in Rising-Cost Environment |
|---|---|---|
| FIFO (First In, First Out) | Oldest inventory cost is assigned to COGS first | Lower COGS, higher taxable income |
| LIFO (Last In, First Out) | Newest (most expensive) inventory cost is assigned to COGS first | Higher COGS, lower taxable income |
| Weighted average cost | Average cost of all units available is assigned to each unit sold | COGS falls between FIFO and LIFO |
| Specific identification | Actual cost of each specific item sold is assigned to COGS | Most accurate; required for unique, high-value items |
COGS components:
| Direct Costs (always capitalized) | Indirect Costs (capitalized under UNICAP if over $32M) |
|---|---|
| Raw materials and merchandise purchased | Purchasing and receiving costs |
| Direct labor (manufacturing workers) | Warehousing and storage costs |
| Freight-in (shipping to the business) | Quality control |
| Manufacturing supplies consumed in production | Depreciation on production equipment |
| Insurance on inventory | |
| Indirect labor (supervisors, handlers) |
How does COGS affect your tax bill?
Which inventory costing method should my business use?
The three primary methods are FIFO (First In, First Out), LIFO (Last In, First Out), and weighted average cost. FIFO assumes the oldest inventory is sold first, which produces lower cost of goods sold and higher taxable income during periods of rising prices. LIFO assumes the newest inventory is sold first, which produces higher cost of goods sold and lower taxable income during inflation, but LIFO requires a LIFO conformity rule (you must use LIFO for financial reporting if you use it for tax). Small businesses with average gross receipts of $32 million or less (for 2026) can use the cash method and avoid accounting for inventory under IRC 471, treating inventory costs as materials and supplies deductible when consumed. Changing your inventory method requires filing Form 3115 and computing a Section 481(a) adjustment to prevent double-counting or omitting income during the transition.
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Yarik Yarosh, CPA. "Cost of Goods Sold: Inventory Accounting Methods and How COGS Affects Your Business Taxes." Blue Cloud CPA, September 5, 2026, updated October 4, 2026. https://bluecloudcpa.com/guides/small-business-tax-implications-selling-inventory-cogs-methods
This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.