As far as accounting goes, the Cost of Goods Sold, or COGS, is one of the most important concepts in many businesses, especially those related to manufacturing and selling tangible products. COGS can include direct costs that are associated with the production of the goods a company sells, further affecting taxable income. Not all industries are as fortunate as these to be able to avail themselves of COGS, mainly because they do not handle tangible products, nor are they in some sort of inventory.

It will discuss the industries that are not allowed to use COGS, why these industries are not allowed to use this accounting method, and how this affects the financial reporting and tax burden on those businesses. Understanding why COGS cannot be calculated for certain industries can, therefore, ensure a better position for businesses in strategic financial management and avoid several common accounting pitfalls.

What is the Cost of Goods Sold?

To determine which industries cannot claim COGS, it's essential to know what COGS is. COGS is short for Cost of Goods Sold. It refers to the direct costs that go into making either a product or a service. This includes raw materials, labor, and manufacturing overhead. Businesses subtract COGS from their total revenue to determine their gross profit.

The greater the COGS, the lesser the gross profit and, consequently, taxable income. COGS are very common in manufacturing, retail, and wholesale as such business lines deal with physical products. In all such business lines, there is heavy reliance on COGS for tax deductions.

Not all businesses have inventory or direct production costs, however. Service-based industries and sectors with core offerings that are mostly intangible or very labor-intensive and fall into a different category. The IRS has strict regulations to ensure that only eligible businesses benefit from the COGS, and those industries are not qualified to be claimed for tax purposes.

Service-Based Industries

These industries include insurance companies, brokerages and banks, doctors and hospitals, lawyers, airlines, real estate and others. These industries are mostly intangible, lacking the physical presence of inventory, and thus cannot be qualified as businesses that directly incur costs on the sale of their products.

Service-based industries are businesses that a significant majority of individuals cannot attribute the possession of COGS. Its members include lawyers, doctors, consultants, and accountants, all great professionals who are involved with providing expertise, guidance, and all other forms of intangible services. As such, their businesses have no tangible products to sell, and they also do not incur direct production costs. In this regard, a law firm charges for representation but does not have any product that would qualify as having COGS. Instead, their costs are classified as operating expenses and not direct costs of producing a good.

The IRS distinguishes between costs directly tied to a product and operational costs for the running of a business that delivers services. Costs like salaries, rent, utilities, and office supplies are general operating costs and cannot be considered to have been directly related to any specific product. Since such businesses earn money through services and not products, they cannot utilize COGS deductions.

Real Estate Companies

Real estate agencies fit into another line of businesses that can't claim COGS. It might appear, at first glance, that selling properties is a "sale of goods," but real estate transactions don't qualify as a sale that fits the COGS definition. Real estate companies help facilitate the purchase and sale of property, but they do not manufacture or produce the property. The costs of acquiring real estate- the commissions and closing fees, for example- are selling expenses.

The revenues of real estate firms are earned through the undertaking of services associated with property transactions, and hence, their business model is no different from all other service industries. Their costs incurred for marketing properties, remuneration of agents, and administrative costs cannot be categorized as the cost of goods produced, as they cannot directly attribute it toward producing a good. Hence, they cannot deduce the same costs under COGS.

Financial Institutions

Similarly, banks, insurance companies, and other financial organizations cannot avail themselves of the costs of goods sold. The business models for them are comprised of managing money, giving loans, and providing financial products, but not manufacturing and selling any tangible product. For example, a bank's major source of income is interest on loans or service fees for financial services. A bank runs operations, which has costs- these are more from an administrative or operational expense rather than a production cost.

Other intangible products are insurance policies, loans, and investment services, which are favorites of financial institutions. Since it does not require any process of production or inventory, expenses incurred cannot be included in the COGS as prescribed by the IRS.

Advertising and Marketing Agencies

Advertising and marketing agencies provide creative services to organizations, such as ad campaign conception and deployment, social media management, or the creation of promotional materials. These agencies generally produce graphs, videos, and written materials; however, these do not fit into the definition of "goods" as interpreted by the IRS. The IRS does not consider marketing material production to be a manufacturing process; thus, these businesses cannot determine COGS.

All other expenses incurred by the business, such as salary for employees, subscription to software, and rent to an office, are considered general business expenses. These costs are vital in running the business but have nothing directly to do with the creation of a physical product; hence, they are not COGSs.

Conclusion

These COGS-ineligible industries include service-related companies, real estate firms, financial institutions, advertising agencies, and SaaS businesses name, a few of which do not work on a tangible product or inventory. Because these industries do things so much differently than manufacturers and retailers, the IRS tax codes do not extend COGS to them. Recognizing these limitations will enable these industries to better find their way in their financial reporting and tax strategies. Though they cannot exploit COGS in other operational costs, they can optimize to minimize their tax liability.