Material cost is one of the essential components of any product’s total cost, and it includes all the expenses incurred in the acquisition, handling, transportation, and storage of materials used in production or manufacturing of goods or services. The material cost can be categorized into two main types: direct material cost and indirect material cost.
Direct Material Cost:
Direct material cost refers to the cost of the raw materials or components used in the production or manufacturing of a product or service that can be directly traced or allocated to the end product. In other words, direct material cost includes all the expenses related to the materials that are an integral part of the finished product, and their cost can be easily measured, traced, and allocated to the end product. Examples of direct materials include wood, steel, plastic, fabric, and other raw materials used in the manufacturing of products.
Characteristics of Direct Material Cost:
1. Direct Traceability
Direct material cost can be physically and conveniently traced to a specific cost unit (product, job, or process). For example, the leather used in shoes or steel in car bodies is directly measurable and identifiable. This traceability allows accurate costing per unit. Without this clear linkage, a cost cannot be classified as direct material. It forms the fundamental basis for prime cost calculation and ensures cost assignment precision.
2. Proportionate to Output
Direct material cost varies directly and proportionately with production volume. If output doubles, direct material consumption—and thus its cost—typically doubles, assuming constant prices. This makes it a classic variable cost. During idle production periods, this cost approaches zero. This behavior helps in break-even analysis, budgeting, and cost control, as management can forecast total direct material cost based on planned production levels.
3. Physical Incorporation into Product
Direct materials physically become an integral part of the finished goods. They are not consumed indirectly (like lubricants) but form the product’s substance or major components. For instance, wood in furniture or flour in bread is visibly present in the final output. This characteristic distinguishes direct materials from indirect supplies. Auditors can physically verify such materials within the product, aiding inventory valuation and quality control.
4. Measurable per Unit with Standardization
Each unit of product consumes a definable, measurable quantity of direct material, allowing setting of standard consumption norms. Engineering studies determine material required per unit (e.g., 2 kg per chair). This standardization enables variance analysis—comparing actual usage against standard. Any excess usage reveals inefficiency or wastage. Such measurability supports material requisition control, reduces scrap, and drives continuous improvement in production processes.
5. Direct Inclusion in Prime Cost
Direct material cost is a primary component of prime cost (along with direct labor and direct expenses). It is directly charged to the cost unit without any allocation or apportionment. In cost sheets, it appears as the first item under “Direct Costs.” This inclusion impacts pricing decisions, profitability analysis, and inventory valuation. Mismanagement of this cost directly erodes gross margins, making it a critical control point for cost accountants.
The formula for calculating the direct material cost can be expressed as follows:
Direct Material Cost = Opening Inventory of Direct Materials + Purchases of Direct Materials – Closing Inventory of Direct Materials
In this formula, the direct material cost is calculated by considering the opening inventory of direct materials at the beginning of the period, adding the purchases of direct materials made during the period, and then subtracting the closing inventory of direct materials at the end of the period.
Indirect Material Cost:
Indirect material cost refers to the cost of the materials used in the production or manufacturing process that cannot be directly traced or allocated to the end product. In other words, indirect material cost includes all the expenses related to the materials that are not an integral part of the finished product but are necessary for the production process to occur. Examples of indirect materials include lubricants, cleaning supplies, and other consumables used in the manufacturing process.
Characteristics of Indirect Material Cost:
1. Not Directly Traceable
Indirect materials cannot be directly identified with a specific product or job. They are used commonly in the production process and support manufacturing activities. Examples include lubricants, cleaning materials, cotton waste, and small tools. Since their exact usage for each unit is difficult to measure, they are treated as indirect costs and included in factory overheads rather than direct production expenses.
2. Small in Value
Indirect materials generally have low monetary value compared to direct materials. Their cost is relatively minor and does not significantly affect the total cost of production individually. Because of their small value, maintaining separate records for each product becomes impractical. Therefore, businesses combine these expenses under overhead costs to simplify accounting and cost control procedures.
3. Used for Supporting Production
Indirect materials help in carrying out production activities smoothly but do not become part of the finished product directly. They support machines, workers, and production operations. For example, grease used in machines and cleaning supplies used in factories assist production indirectly. These materials ensure efficient manufacturing and maintenance of equipment within the organization.
4. Included in Factory Overheads
The cost of indirect materials is treated as part of factory or manufacturing overheads. Since these materials cannot be assigned directly to a particular product, their expenses are distributed among all products produced. This helps in proper allocation of production costs and accurate preparation of cost sheets and financial records.
5. Difficult to Measure Accurately
The exact quantity of indirect materials consumed for producing one unit of output is difficult to determine. Their usage may vary daily depending on production requirements and maintenance activities. Because accurate measurement is not possible, companies estimate and allocate their cost through overhead absorption methods in cost accounting.
Indirect Material Formula:
The calculation of indirect material cost is usually more complex as it involves allocating or apportioning the cost of indirect materials to the relevant cost centers or products. While there is no specific formula for indirect material cost, the general approach involves determining the usage of indirect materials based on cost drivers and allocating the cost accordingly. Here are a few common formulas used for allocating indirect material cost:
Indirect Material Cost = Total Overhead Cost x (Indirect Material Usage / Total Usage of Cost Driver)
In this formula, the indirect material cost is allocated based on the proportion of indirect material usage relative to the total usage of the cost driver. The cost driver can be a relevant factor such as machine hours, labor hours, or any other appropriate basis for allocating overhead.
Activity-Based Costing (ABC) Formula:
Indirect Material Cost = (Indirect Material Usage x Indirect Material Cost Pool) / Total Activity Usage
In ABC, indirect material cost is allocated based on the usage of activities that consume indirect materials. The formula calculates the proportion of indirect material usage relative to the total activity usage and multiplies it by the cost of the indirect material cost pool.
Key differences between Direct and Indirect Material Costs:
| Basis of Comparison | Direct Material Cost | Indirect Material Cost |
|---|---|---|
| Identification | Easily Identifiable | Not Identifiable |
| Product Relation | Directly Related | Indirectly Related |
| Cost Allocation | Direct Charge | Overhead Allocation |
| Cost Value | High Value | Low Value |
| Measurement | Easily Measured | Difficult Measured |
| Usage | Main Production | Support Production |
| Traceability | Fully Traceable | Not Traceable |
| Accounting Treatment | Prime Cost | Factory Overhead |
| Nature | Specific Cost | Common Cost |
| Record Keeping | Separate Records | Combined Records |
| Impact on Product | Major Impact | Minor Impact |
| Examples | Raw Material | Lubricants |
| Cost Control | Easier Control | Difficult Control |
| Consumption | Product Specific | General Use |
| Cost Per Unit | Directly Included | Indirectly Included |
Valuation of Materials:
1. First–In–First–Out (FIFO)
Under FIFO, materials received first are issued first. The assumption follows natural physical flow—oldest stock moves out before newer purchases. This method uses the earliest purchase price for each issue until that lot is exhausted, then moves to the next. During rising prices, FIFO shows lower cost of goods sold (using older, cheaper prices) and higher closing stock value (using recent, higher prices). It is suitable for perishable goods or where stock rotation is essential. However, it can lead to fluctuating profit margins. FIFO is accepted by accounting standards but may create tax advantages or disadvantages depending on price trends. The method requires detailed lot-wise record-keeping for accurate application.
2. Last-In-First-Out (LIFO)
LIFO assumes the latest materials purchased are issued first. Physical flow may differ, as old stock remains in inventory while newer stock is consumed. During inflation, LIFO charges higher recent costs to production, resulting in higher cost of goods sold and lower reported profits—beneficial for tax savings. Closing stock is valued at older, lower prices. LIFO matches current costs with current revenues, providing better income measurement. However, it is banned under IFRS and Ind AS, though permitted under US GAAP. Balance sheet valuation becomes less realistic as old costs may be outdated. LIFO requires careful layering records and may lead to artificial profit manipulation during price fluctuations.
3. Weighted Average Cost (WAC)
WAC calculates the average cost of all materials in stock, dividing total purchase cost (including opening stock) by total quantity available. Every new purchase triggers recalculation of the average. This method smoothens price fluctuations, reducing extreme profit variations seen in FIFO or LIFO. It is simple to operate and ideal for bulk, homogeneous materials like fuel or grains. WAC avoids the need to track specific batches. However, it may not reflect exact physical flow during rapid price changes. The average cost often falls between FIFO and LIFO extremes. It is widely accepted under IFRS and GAAP. Periodic or perpetual systems can compute WAC, but perpetual requires recalculation after each receipt.
4. Specific Identification Method
Used for unique, high-value, or job-specific materials (e.g., precious stones, customized components). Each material unit is identified individually with its actual purchase cost. Upon issue, the exact cost of that specific unit is charged to production. This method provides perfect matching of cost and revenue, ideal for low-volume, high-value inventory. It eliminates averaging or assumption-based costing. However, it is impractical for interchangeable bulk materials due to excessive record-keeping. Specific identification may allow income manipulation by choosing which identical units to issue. It suits industries like automobiles (engine numbers) or jewelry. This method is mandatory where physical identification is possible and cost differences are significant.
5. Base Stock Method
A minimum quantity of material (base stock) is always retained and valued at its original historical cost, never issued under normal conditions. Only stock above base level is valued using FIFO, LIFO, or average. This method ensures operational continuity during emergencies. It treats base stock like a fixed asset. The approach provides stability in valuation but is not recognized by most accounting standards (IFRS/GAAP). It artificially inflates closing stock value using outdated prices, distorting profit measurement. Used mainly for internal management reporting in industries requiring safety stock (e.g., strategic reserves). Changing base stock quantity violates the method’s principle. It requires clear policies separating base from working stock.
6. Simple Average Price
All purchase prices of available lots are added and divided by the number of lots, ignoring quantities purchased. No weightage is given to larger or smaller receipts. For example, two purchases of 100 units at 10 and 1000 units at 12 give simple average $11. This method is extremely easy to compute without stock registers. However, it severely distorts cost when purchase quantities differ significantly—large cheap purchases get undervalued in issue cost. Suitable only for homogeneous materials with similar lot sizes. It ignores price movement patterns. Not recommended for financial reporting but used in some internal cost estimates. Simple average can lead to unrealistic inventory write-offs and poor pricing decisions. Better alternatives like weighted average correct this bias.
