What expense category is Purchase of Materials?

Businesses purchase materials for various reasons – as raw inputs for manufacturing, as components for assembly, as finished goods for resale, or as supplies for day-to-day operations. Correctly categorizing the "Purchase of Materials" is fundamental for accurate financial reporting, particularly for calculating Cost of Goods Sold (COGS), valuing inventory, and determining taxable income.

The right expense category depends critically on how the materials are used within the business. This guide clarifies the classification and tax treatment for different types of material purchases.

Purchase of Materials Expense Category

The classification hinges on the intended use of the materials:

1. Direct Materials for Production or Resale

• This includes raw materials transformed into finished goods, components assembled into products, or finished goods purchased explicitly for resale (inventory).
• Accounting/Tax Treatment: These costs are NOT immediately expensed. They are capitalized as part of the Inventory asset on the balance sheet.
• Category: The cost flows into the Cost of Goods Sold (COGS) calculation on the income statement only when the final product containing or representing the material is sold. IRS Publications 535 and 334 confirm that the cost of products or raw materials is a key component of COGS.

2. Indirect Materials Used in Production

• These are materials consumed during the manufacturing process but not part of the final product (e.g., lubricants, small tools, factory cleaning supplies).
• Category: Often treated as Factory Overhead and allocated to Inventory/COGS. Alternatively, some might be expensed as Supplies Expense depending on accounting policies.

3. Materials for Operations / Supplies

• This includes materials and supplies used in running the business that are not incorporated into inventory or held for resale (e.g., office supplies, cleaning supplies, maintenance materials, materials used in providing a service).
• Category: These are treated as Operating Expenses, typically classified under Supplies Expense, or more specific accounts like Office Supplies, Maintenance Supplies, etc.

Some Important Considerations While Classifying Purchase of Materials Expenses

Proper handling of material purchases involves several key considerations:

• Inventory Accounting Required? Businesses where the production, purchase, or sale of merchandise is an income-producing factor generally must use inventory accounting. This means tracking materials meant for sale (Direct Materials) as inventory assets until sold.
• Small Business Taxpayer Exception: Many small businesses (generally <= $30M average annual gross receipts per Pub 334/535 threshold provided) are exempt from the requirement to maintain inventories for tax purposes or can use simplified methods, such as treating inventoriable items as non-incidental materials and supplies (deducting when used/consumed). This can significantly simplify bookkeeping.
• Uniform Capitalization Rules (UCR): Businesses subject to UCR (certain producers/resellers not meeting the small business exception) must capitalize not only direct material costs but also an allocable share of indirect costs (like purchasing and storage) into the inventory value.
• Freight-In: The cost of shipping to receive materials is considered part of the material's cost and should be included in inventory value (for COGS items) or the cost of supplies (for operating items).
• Purchase Discounts: Record material purchases net of any trade discounts. Cash discounts for prompt payment should either reduce the recorded cost of materials or be credited to a separate income account.
• Personal Use: If materials intended for business use are withdrawn for personal use, their cost must be removed from business expenses (e.g., subtracted from Purchases in the COGS calculation).
• Recordkeeping: Maintain detailed supplier invoices showing materials purchased, quantities, unit costs, freight charges, discounts received, and proof of payment. If inventory accounting is used, maintain accurate inventory tracking records (counts, valuation).

Examples of Purchase of Materials Expenses

Direct Materials (-> Inventory/COGS)

• Lumber for a furniture maker.
• Fabric for a clothing manufacturer.
• Electronic components for an assembler.
• Finished goods bought by a retailer for resale.
• Food ingredients for a restaurant.

Indirect Materials (-> Overhead/COGS or Supplies)

• Machine lubricants used in a factory.
• Sandpaper used in furniture making.
• Small, non-tracked hardware used in assembly.

Operating Materials (-> Supplies Expense)

• Paper, pens, toner (Office Supplies).
• Cleaning chemicals, paper towels (Cleaning Supplies).
• Spare parts for equipment maintenance (Maintenance Supplies).
• Oil and filters used by an auto repair shop during service (could be Supplies or potentially allocated to COGS depending on method).

Tax Implications of Purchase of Materials Expenses

Recovery Method

• Inventory/COGS Materials: Costs are recovered through Cost of Goods Sold when the inventory is sold. The deduction is matched with the revenue.
• Operating Supplies: Costs are generally deducted as Supplies Expense in the year they are used or consumed (or potentially when purchased if incidental and meeting IRS criteria).

Timing

COGS recovery happens upon sale. Operating supplies expense follows cash/accrual timing rules related to payment or consumption.

UCR & Small Business Exception 

UCR dictates capitalization for non-exempt businesses. The small business exception allows simpler methods, potentially faster deduction of material costs.

Where to Report (Schedule C)

For sole proprietors:

• Materials included in COGS are reported in Part III. Line 36 captures "Purchases..." and Line 38 captures "Materials and supplies" used in production.
• Operating materials/supplies are reported in Part II, Line 22 ("Supplies").

How Fyle Can Automate Expense Tracking

Managing numerous material purchases requires organized tracking of invoices and payments. Here’s how Fyle can help:

• Capture Purchase Transactions: Track payments for materials and supplies made via company credit card using Fyle's real-time feeds. Manage supplier invoices paid via ACH or check by attaching the invoice and proof of payment within Fyle.
• Centralize Documentation: Store digital copies of supplier invoices, packing slips, and payment confirmations securely, linked to the specific purchase transaction.
• Consistent Categorization: Use Fyle to reliably categorize purchases, distinguishing between operating supplies (e.g., "Office Supplies," "Maintenance Supplies") and flagging purchases intended for inventory/COGS for proper handling within the main accounting system.
• Integration with Accounting Software: Fyle syncs categorized operating supply expense data and purchase details directly to your accounting system (QuickBooks, Xero, NetSuite, Sage Intacct). This provides accurate data for expense reporting and supports inventory tracking and COGS calculations managed within the accounting platform.

The correct expense category for "Purchase of Materials" depends entirely on the material's intended use. Materials becoming part of inventory for resale or production are capitalized and recovered through COGS, subject to inventory accounting rules and potential UCR impact (unless the small business exception applies). 

Materials used for general business operations are expensed as Supplies. Accurate classification and recordkeeping, potentially aided by tools like Fyle for capturing transactions and documents, are essential for correct financial reporting and tax compliance.