To find direct materials cost, take your beginning raw materials inventory, add net purchases for the period, and subtract ending raw materials inventory. What remains is the value of materials actually consumed in production. That figure flows into cost of goods sold, which shapes your gross profit and your taxable income, so the inputs need to be complete and the valuation method has to be applied consistently.
The Formula
Direct Materials Used = Beginning Raw Materials Inventory + Purchases − Ending Raw Materials Inventory
Beginning inventory is the dollar value of raw materials on hand at the start of the period. Purchases cover everything bought during the period, adjusted for freight, returns, and discounts. Ending inventory is what remains unused at the close. Subtracting the ending balance isolates the materials you actually put into production.
A Worked Example
A furniture manufacturer starts the quarter with $40,000 in lumber and hardware. During the quarter, it buys another $95,000 in raw materials, a figure that already reflects freight charges and a small purchase return. At quarter’s end, a physical count shows $28,000 in unused materials in the warehouse.
- Beginning inventory: $40,000
- Plus purchases: $95,000
- Minus ending inventory: $28,000
- Direct materials used: $107,000
That $107,000 feeds into cost of goods sold, reducing gross profit dollar for dollar. If the ratio of direct materials to revenue climbs over several quarters, it may point to rising supplier prices, more waste, or contracts due for renegotiation.
What Counts as a Direct Material
Direct materials are tangible components you can trace to a specific finished product. The steel in a car frame, the fabric in a garment, and the wood in a piece of furniture all qualify. The test is whether you can identify the material in the finished good and assign its cost to that unit of production.
Indirect materials are consumed during manufacturing but are impractical to trace to a single product. Machine lubricants, cleaning solvents, and small fasteners used across hundreds of products are typical examples. They still affect profitability, but they run through manufacturing overhead rather than the direct materials line. Misclassifying either way distorts gross margin and can raise questions during a financial audit or an IRS examination.
Adjusting the Purchases Figure
The purchases number is rarely just the base price on your supplier invoices. Several items push it up or down, and the net paid is what belongs in the formula.
What Increases Purchases
Freight-in charges are part of the cost of the materials themselves, not a separate operating expense. The IRS treats freight as an element of an asset’s cost basis, along with sales tax and installation costs where applicable.1Internal Revenue Service. Publication 551 (12/2025), Basis of Assets Import duties on components sourced internationally also belong in the total. Many states exempt raw materials used in manufacturing from sales tax, so check your state’s rule before folding sales tax into the cost.
What Reduces Purchases
Purchase returns lower net purchases when you send defective or wrong materials back to a supplier. Purchase allowances work similarly: the supplier drops the price and you keep goods with minor damage. Trade discounts for certain classes of buyers and cash discounts for paying early both reduce the true cost. Use the net figure.
Pulling the Inventory Numbers
Beginning inventory comes from the prior period’s ending balance in your general ledger. If last period closed with $40,000 in raw materials on hand, that is where this period starts.
For purchases, collect every vendor invoice from the current period. Each should show unit price, quantity received, and transaction date, along with supporting records for freight, duties, returns, and discounts. The IRS requires records that support every item on your return, and complete records speed up any examination.2Internal Revenue Service. Publication 583 (12/2024), Starting a Business and Keeping Records
Most businesses keep this in an inventory ledger, either a spreadsheet or accounting software, tracking SKU numbers, supplier names, receipt dates, and quantities. The detail supports the cost of goods sold line on Form 1120 for corporations or Schedule C for sole proprietors.3Internal Revenue Service. About Form 1120, U.S. Corporation Income Tax Return
Choosing an Inventory Valuation Method
The dollar value assigned to ending inventory depends on the valuation method you use. Because ending inventory is subtracted in the formula, a higher ending inventory lowers direct materials cost and raises reported profit; a lower ending inventory does the opposite. Three methods are common in the United States.
- First-In, First-Out (FIFO) assumes the oldest materials are used first. When prices rise, FIFO produces a higher ending inventory value, a lower cost of goods sold, and higher reported profit.
- Last-In, First-Out (LIFO) assumes the newest materials are used first. During inflation, LIFO raises cost of goods sold and lowers taxable income because the more expensive recent purchases are recognized first. LIFO is permitted under U.S. GAAP but prohibited under International Financial Reporting Standards.
- Weighted Average Cost averages the cost of all available units into one per-unit value, smoothing price fluctuations and landing between FIFO and LIFO in effect.
Inventory must be valued on a basis that conforms to the best accounting practice in your industry and most clearly reflects your income.4Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories Once you adopt a method, the IRS expects consistent application year to year. Switching methods requires filing Form 3115 to request a change in accounting method.5Internal Revenue Service. About Form 3115, Application for Change in Accounting Method
Writing Down Inventory When Market Value Drops
If the market value of your raw materials falls below what you paid, you may need to write the inventory down. Under the lower of cost or market rule, you compare the cost of each item to its current market value and use whichever is lower. One exception applies to goods already committed under a firm, non-cancelable sales contract at a fixed price. Those stay at cost because you are protected against actual loss.6eCFR. 26 CFR 1.471-4 – Inventories at Cost or Market, Whichever Is Lower
The definition of market depends on your valuation method. Businesses using FIFO or weighted average compare cost to net realizable value, meaning estimated selling price minus costs to complete and sell. Businesses using LIFO compare cost to current replacement cost, subject to a ceiling (net realizable value) and a floor (net realizable value minus a normal profit margin). Under U.S. GAAP, once inventory is written down, the write-down generally cannot be reversed even if prices recover.
A write-down reduces ending inventory, which increases direct materials cost for the period. When commodity prices drop sharply, skipping this rule overstates both ending inventory and gross profit.
Handling Waste and Spoilage
Manufacturing produces some waste. How you account for it depends on whether the spoilage is normal, meaning an expected part of the process, or abnormal, meaning it results from an unusual event like equipment failure or a contaminated batch.
- Normal spoilage folds into inventory costs. A certain level of waste is expected, so its cost spreads across the good units produced. This effectively raises the per-unit direct materials cost.
- Abnormal spoilage is expensed immediately in the period it occurs rather than capitalized into inventory. The loss is unusual and does not belong in product costs.
Scrap materials with some recovery value, such as metal shavings sold to a recycler, reduce net materials cost when the proceeds are credited back. Keep records of scrap sales so the offset is reflected in your cost calculations and tax filings.
Why Accuracy Matters
Direct materials cost flows into cost of goods sold, which determines taxable income. Reporting it inaccurately, whether through sloppy records or deliberate manipulation, carries real consequences. The IRS imposes an accuracy-related penalty equal to 20 percent of any underpayment caused by negligence, disregard of rules, or a substantial understatement of income tax. That penalty rises to 40 percent for gross valuation misstatements.7Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments The penalties apply to any business that understates its tax liability, whether a corporation, partnership, or sole proprietorship.
The IRS places the burden of proof on you to substantiate every deduction and expense. A complete set of invoices, inventory counts, and ledger entries makes that straightforward and gives your direct materials calculation a defensible foundation.8Internal Revenue Service. Recordkeeping