How to Calculate Cost of Materials Used

The Cost of Materials Used (CMU) represents the total expense of raw materials and components consumed by a business during a specific accounting period. This calculation is fundamental for companies that manufacture goods or utilize raw materials in delivering their services. Understanding CMU is crucial for maintaining accurate financial records, analyzing profitability, and effectively managing inventory levels. It provides a clear picture of the direct material input into the production process, directly influencing a company’s financial statements and operational decisions.

Defining Material Costs

Material costs encompass more than just the initial price paid for raw materials or components. These costs include all direct expenditures necessary to bring materials to their current location and condition, making them ready for use in production. The actual purchase price of the raw materials forms the base of this cost.

Other direct costs are added to the material’s cost. Freight-in, the shipping expenses to transport materials to the business’s facility, is a prime example. Import duties, taxes, or tariffs on the acquisition of materials from international suppliers are included. Any other direct charges, such as handling fees or insurance during transit, are capitalized into the material’s cost.

Costs not directly attributable to getting materials ready for use are excluded from material costs. These include purchase returns, which reduce the quantity of materials acquired, and purchase allowances or discounts, which lower the net cost paid. Administrative overhead, general storage costs after materials are ready for use, or expenses related to finished goods inventory are not considered part of the raw material cost.

Understanding Inventory Valuation Methods

The determination of the “cost” of materials used is significantly influenced by the inventory valuation method a business employs. Generally Accepted Accounting Principles (GAAP) in the United States permit several methods for valuing inventory. These methods dictate how the cost of materials acquired at different times and prices is allocated to both the materials consumed and the materials remaining in inventory.

The First-In, First-Out (FIFO) method assumes that the first materials purchased are the first ones used in production. Under FIFO, the cost of materials used reflects the older, earlier costs of inventory. Conversely, the ending inventory typically consists of the most recently purchased materials, reflecting more current costs. This method often aligns with the physical flow of goods, especially for perishable items.

The Last-In, First-Out (LIFO) method operates on the assumption that the last materials purchased are the first ones used. This means the cost of materials used reflects the more recent, higher costs during periods of inflation. The ending inventory, under LIFO, is then valued based on the older, initial costs of inventory. It is important to note that LIFO is a method permitted under U.S. GAAP but is not allowed under International Financial Reporting Standards (IFRS).

The Weighted-Average Method calculates an average cost for all materials available for use during a period. This average cost is determined by dividing the total cost of materials available by the total number of units available. Both the cost of materials used and the ending inventory are then valued using this single average cost. This method smooths out price fluctuations and can be simpler to apply, particularly for businesses with a large volume of similar materials.

Calculating the Cost of Materials Used

Calculating the Cost of Materials Used (CMU) relies on a straightforward formula that accounts for the materials available and those remaining. The primary formula is: Beginning Inventory of Materials + Net Purchases of Materials – Ending Inventory of Materials = Cost of Materials Used. This formula effectively tracks the flow of materials into and out of the raw material inventory during an accounting period.

The “Beginning Inventory of Materials” represents the value of raw materials on hand at the start of the current accounting period. This figure is carried over from the prior period’s ending inventory balance. It serves as the starting point for determining the total materials available for production.

“Net Purchases of Materials” accounts for the total cost of materials acquired during the period, adjusted for any reductions. This is calculated as Gross Purchases of Materials minus Purchase Returns, Purchase Allowances, and Purchase Discounts. Gross Purchases include the purchase price, freight-in, import duties, and other direct costs to bring materials to a ready-for-use state.

“Ending Inventory of Materials” represents the value of raw materials remaining at the close of the accounting period. The valuation of beginning and ending inventory, and the cost assigned to net purchases, depends on the inventory valuation method chosen. The specific valuation method, such as FIFO, LIFO, or weighted-average, determines the ending inventory value, which impacts the CMU.

Businesses utilize inventory systems, either periodic or perpetual, to track their material quantities and costs. A periodic system requires a physical count of inventory at the end of the period to determine the ending inventory figure. Conversely, a perpetual system continuously updates inventory records with each purchase and issuance, providing real-time balances for beginning and ending inventory. Both systems ultimately provide the necessary input numbers for the CMU formula, though the process of obtaining those numbers differs.

Impact on Financial Reporting

The calculation of the Cost of Materials Used holds significant implications for a company’s financial statements. CMU is a primary component in determining the Cost of Goods Sold (COGS) for manufacturing businesses. To arrive at COGS, CMU is combined with direct labor and manufacturing overhead to calculate total manufacturing cost. This total is then adjusted by Work-in-Process and Finished Goods inventory changes.

COGS is an expense reported on the income statement, directly impacting a company’s gross profit. Gross profit is calculated by subtracting COGS from net sales revenue. This figure contributes to the calculation of net income, as other operating expenses are deducted from gross profit. An accurate CMU ensures COGS is correctly stated, leading to accurate gross profit and net income figures.

Beyond financial statement accuracy, an accurate CMU calculation is important for business analyses and decisions. It provides insights for setting product pricing, as material costs are a major determinant of production expenses. CMU figures are useful in developing effective budgets and forecasts for future production. It aids in performance analysis, allowing management to assess material utilization efficiency and identify areas for cost control.