COGS vs. operating expenses: what's the difference?

The one-line test: if you only spent the money because you sold (or plan to sell) a product, it's probably COGS. If you'd spend it anyway — even in a month with zero sales — it's probably an operating expense.

What counts as cost of goods sold

COGS is the direct cost of the products you sold during the year. Per IRS Publication 334, chapter 6, it's figured on Schedule C Part III (lines 35–42) and generally includes:

Inventory purchases Merchandise you buy to resell — the candle inventory a shop orders, the parts a repair business keeps in stock.

Raw materials Materials that become part of the product — fabric for a clothing maker, flour for a baker.

Packaging & freight-in Costs to get products ready and delivered to you — shipping charges on inventory you ordered, boxes that ship with the product.

The key mechanic: COGS is not simply "what you bought this year." It's beginning inventory + purchases − ending inventory. Inventory you bought but haven't sold yet sits on your shelf (and on your books) as an asset until the year you sell it. That's why the IRS requires businesses that sell products to account for inventory rather than deducting purchases outright.

What counts as an operating expense

Operating expenses are the costs of running the business day to day, deducted in Schedule C Part II. The IRS test is "ordinary and necessary": ordinary means common and accepted in your trade; necessary means helpful and appropriate. Rent, software, advertising, shipping to customers, and professional fees all live here.

Unlike COGS, operating expenses are generally deducted in the year you pay them — no inventory math involved.

Why the distinction matters

Different lines on Schedule C. COGS is subtracted from revenue to get gross profit (Part I/III); operating expenses are listed individually in Part II. Misclassifying moves numbers between sections and can change how your return reads.
Timing. Unsold inventory isn't deductible yet. Expensing it early overstates this year's deductions and understates next year's.
Clearer books. Knowing your gross margin (revenue minus COGS) tells you whether your products are actually profitable before overhead — something a lumped-together expense total hides.

Tricky examples, decided

Shipping supplies you send orders in — if the packaging is part of delivering the product, it's typically a COGS "other cost" (line 39). Postage to mail customer orders is usually an operating expense.
Freight you pay to receive inventory — COGS (freight-in). Freight you pay to ship to customers — operating expense.
Tools used to make the product — small consumable tools can be materials/supplies; a $3,000 machine is an asset, not COGS (see Assets and depreciation).
Your own labor — a sole proprietor's own labor is never COGS. You can't deduct wages you pay yourself.

How this maps in Tidy Orders

Tidy Orders' Inventory / COGS category covers inventory purchases, raw materials, packaging, freight-in, and production supplies. Everything else day-to-day lands in Operating expenses. When a purchase could go either way, it appears in your Review Queue — your decision there is remembered for the next purchase from that vendor.

From the IRS

Publication 334, Tax Guide for Small Business — chapter 6, "How To Figure Cost of Goods Sold," and chapter 8, "Business Expenses."
Instructions for Schedule C — line-by-line definitions for Part II expenses and Part III cost of goods sold.

This guide is education, not tax advice. For your specific situation, talk to a CPA or enrolled agent.