Raw materials are the basic substances a company uses as inputs in manufacturing to create finished goods. Accurately calculating the cost and quantity of these materials is foundational for any manufacturing business. This calculation directly influences the cost of goods sold (COGS), which determines profitability and informs pricing strategy. Precise tracking is necessary for effective budgeting and maintaining production efficiency.
Determining Material Requirements for Production
The initial step in managing raw material cost is determining the physical quantity required for a production run. This planning is formalized through the Bill of Materials (BOM), a comprehensive list specifying the exact type and quantity of every raw material needed to manufacture a single finished unit. The BOM provides the theoretical net requirement, which is the baseline quantity before accounting for inefficiencies.
A production plan must incorporate a scrap allowance to calculate the gross material requirement, which is the actual amount that must be issued from inventory. Material is often lost during processing due to trimming, defects, or handling, a factor known as the scrap rate.
To determine the necessary input, the formula is Gross Material Required = Net Requirement / (1 – Scrap Rate, as a decimal). For example, if a unit needs 10 pounds of steel and the scrap rate is 5%, the gross requirement is 10 / (1 – 0.05), or approximately 10.53 pounds of steel.
Calculating the Total Cost of Raw Materials
The true cost of a raw material, known as the “landed cost,” extends beyond the price paid to the supplier. Landed cost is the total expense required to bring the material into inventory and prepare it for use in production. Accurately determining this figure ensures that the Cost of Goods Sold reflects the full economic outlay.
This total cost must include the initial purchase price along with all associated acquisition expenses. These expenses typically cover:
- Freight and shipping charges.
- Customs duties and tariffs for imported goods.
- Specific taxes.
- Handling and storage costs.
Tracking Raw Material Inventory Levels
Tracking inventory levels monitors the physical flow of materials into and out of the warehouse over a specific period. This process uses the inventory identity formula: Beginning Inventory + Purchases – Usage = Ending Inventory. This calculation focuses on the physical quantity of materials, establishing a foundation for later financial valuation.
Companies use either a periodic or a perpetual system to manage these levels. A periodic system involves performing a physical count of stock at the end of an accounting period to determine the final inventory balance. The perpetual system continuously updates inventory records in real-time with every material receipt and withdrawal, often through automated scanning or inventory management software.
Calculating Raw Material Usage and Consumption
Determining the value of materials consumed is necessary for calculating the Cost of Goods Sold for an accounting period. This calculation links physical inventory levels to financial statements by converting the quantity of materials used into a dollar amount.
The formula for consumption is: Beginning Raw Material Inventory (Value) + Purchases (Value) – Ending Raw Material Inventory (Value) = Raw Materials Consumed (Value). This result represents the total cost of materials moved into the production process. This consumption value is then transferred to the Work-in-Process inventory account, where it combines with labor and overhead costs to create the total cost of finished goods.
Valuing Raw Material Inventory (The Accounting Methods)
Once the quantity of materials consumed is known, an accounting method must be applied to assign a dollar value to that consumption and the remaining inventory. This valuation is necessary because the purchase price of raw materials often fluctuates, meaning identical units in stock may have been acquired at different costs. The choice of valuation method significantly impacts the reported Cost of Goods Sold and the value of the ending inventory on the balance sheet.
The First-In, First-Out (FIFO) method assumes that the oldest materials purchased are the first ones used in production. In an inflationary period, where costs are rising, FIFO assigns the older, lower costs to the Cost of Goods Sold. This results in a higher reported net income and a higher valuation for the ending inventory.
The Last-In, First-Out (LIFO) method operates under the opposite assumption, treating the newest acquired materials as the first ones used. During periods of rising prices, LIFO assigns the most recent, higher costs to the Cost of Goods Sold, resulting in a lower reported net income and often a tax advantage. However, LIFO is prohibited under International Financial Reporting Standards (IFRS) and is primarily used only by companies operating under US Generally Accepted Accounting Principles (GAAP).
The Weighted Average Cost (WAC) method smooths out the effects of price fluctuations by calculating a new average cost every time a material purchase occurs. This average is determined by dividing the total cost of materials available for use by the total number of units. This single average cost is then applied to all materials consumed and to the remaining ending inventory.