4.6/51670+ reviewsFor businesses involved in manufacturing, production, or even crafting, raw materials are the fundamental building blocks of their products. Understanding how to properly account for raw materials expenses is essential for accurate financial reporting, effective inventory management, precise job costing, and compliant tax filing. Unlike typical operating expenses, raw materials aren't immediately deducted; instead, their costs are primarily absorbed into the Cost of Goods Sold (COGS).
This article will delve into how raw materials are categorized, key considerations for their accounting treatment, examples, tax implications, and how Fyle can help in tracking the acquisition of these vital components.
When a business purchases raw materials, the cost isn't typically recorded directly as an "expense" in the same way rent or utility bills are. Instead, raw materials are considered part of your Inventory and their cost is recognized through the Cost of Goods Sold (COGS) when the finished products are sold.
Here's a breakdown:
It's crucial to remember that costs included in COGS cannot be deducted again elsewhere as a business expense.
Businesses that produce, purchase, or sell merchandise must generally value their inventory at the beginning and end of each tax year to determine COGS. The method used must clearly reflect income and be consistent from year to year.
The cost of raw materials includes the invoice price less any trade discounts. It also includes freight-in and other charges necessary to obtain the materials. Cash discounts can either be deducted from purchases or credited to a separate discount account.
Manufacturers and certain resellers are subject to UNICAP rules (Internal Revenue Code Section 263A), which require capitalizing all direct costs and an allocable share of indirect costs associated with producing or acquiring property for resale. This means some costs related to purchasing, handling, and storing raw materials must be included in inventory and COGS, rather than being expensed immediately. Small business taxpayers (average annual gross receipts of $30 million or less for 2024, as per Pub 334 ) are generally exempt from UNICAP rules.
It's important to distinguish raw materials, which become an integral part of the final product, from general business supplies or materials that are consumed during the manufacturing process but are not part of the product (e.g., cleaning supplies, small tools not capitalized, administrative supplies). These other supplies are typically expensed as incurred, subject to inventory rules if they are substantial non-incidental materials and supplies.
Meticulous recordkeeping is essential. Businesses should maintain detailed records of all raw material purchases (invoices, proof of payment), usage in production, and physical inventory counts. The IRS document "What kind of records should I keep?" provides guidance on the types of supporting documents to retain for purchases, including canceled checks, receipts, and invoices.
The cost of shipping raw materials to your facility is part of the cost of those materials and is included in COGS.
If raw materials are withdrawn from inventory for personal use, their cost must be excluded from COGS. This is typically done by crediting purchases or sales and charging a drawing account.
The specific items considered raw materials will vary widely depending on the industry:
The primary tax implication for raw materials is their role in calculating the Cost of Goods Sold (COGS), which is a direct reduction from your gross receipts to arrive at gross profit.
Unlike operating expenses, you don't deduct the cost of raw materials when you buy them. They become part of your inventory asset.
The cost of raw materials is effectively deducted when the finished goods containing them are sold. This is reflected in the COGS calculation on your tax return (e.g., Schedule C, Part III for sole proprietors; Form 1125-A for corporations).
The method used to value your beginning and ending inventory (e.g., cost method, or lower of cost or market) significantly impacts your COGS and, therefore, your taxable income. IRS Publication 334 (Chapter 2) states if inventory is necessary to account for income, an accrual method must generally be used for sales and purchases, unless you qualify as a small business taxpayer who can opt out of keeping inventory.
If applicable, these rules require certain direct and indirect costs, including those related to acquiring and storing raw materials, to be capitalized into inventory. This can delay the deduction of these costs until the goods are sold.
To substantiate your COGS deduction, the IRS requires detailed records of inventory, purchases, and production costs. The IRS document "What kind of records should I keep?" lists specific documents like invoices and proof of payment for purchases.
While Fyle is an expense management platform and not a dedicated inventory management system, it plays a crucial role in tracking and managing the acquisition of raw materials, especially when these purchases involve company credit cards, out-of-pocket employee expenses needing reimbursement, or require detailed documentation before being entered into your inventory and accounting systems.
Here's how Fyle can help:
If raw materials are purchased using company credit cards (from Visa, Mastercard, Amex, etc.), Fyle’s real-time feeds capture these transaction details instantly. This allows for immediate visibility into raw material procurement spending.
Employees or purchasing departments can easily submit invoices and receipts for raw material purchases directly into Fyle via email forwarding (e.g., from Gmail or Outlook), SMS, mobile app, or direct upload. This ensures all necessary supporting documentation is digitized and attached to the corresponding transaction.
For purchases of raw materials, Fyle can help in initially categorizing these transactions (e.g., "Raw Material Purchases," "Inventory") before they are synced to your accounting system. Rules can be set up for automatic coding based on vendors or other criteria.
Fyle’s two-way integrations with accounting systems like QuickBooks (Online & Desktop), Xero, NetSuite, and Sage Intacct ensure that data on raw material purchases is accurately and efficiently transferred. This can create bills or credit card charges in your accounting software, which can then feed into your inventory valuation and COGS calculations.
If raw materials are purchased for specific projects or jobs, Fyle’s project tracking features allow you to allocate these costs accordingly from the point of purchase. This aids in accurate project profitability analysis before these costs flow into overall COGS.
Fyle’s dashboards can provide insights into spending on raw material procurement, helping identify trends, track supplier costs, and manage budgets related to material inputs.
By streamlining the capture and documentation of raw material purchases, Fyle helps ensure that accurate cost data flows into your inventory and accounting systems, laying a solid foundation for correct COGS calculation and tax reporting.
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