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Corporations use large quantities of raw materials in the production process. Computing the material cost is a little complex. A corporation has large quantities of materials on stock and may produce at full capacity for several months without purchasing any raw materials. On the other hand, it may run out of several materials on the same month and make huge purchases of materials in a single month with costs that are much higher than the income the corporation makes in several months.
These variations in cost of materials can make the corporate finance hard to understand. To make it easier to understand and more stable, we look at he materials used each month and take the value of the used materials as the cost of materials for the month. This is done independent of any purchase of materials on the market.
When materials are used, the value of all materials on stock is reduced, and the reduction in their value is in fact the cost of the materials used in that month.
On the other hand, the purchase of materials on the market is not considered to be a cost for the corporation. The purchase of materials is in fact exchange of cash for materials. The total value of materials plus the cash remains the same. The value of raw materials a corporation has in stock is calculated each month and it shows on the cash flow on the corporation. When raw materials are purchased, cash is paid out and cash reserves in the corporation may drop sharply but the cash is replaced by an increased value of the raw materials the corporation has in stock.
Cash may run out if the cost of materials is very high and new loans must be taken to bring the cash back to the green.