Material Cost-Direct and indirect material, Valuation of Materials

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:

• Direct material costs are easy to identify and measure because they are directly related to the end product’s production process.
• Direct material costs can be traced and allocated to specific products, making it easier to determine the cost per unit of production.
• Direct material costs are typically high in value and can have a significant impact on the total cost of the finished product.

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:

• Indirect material costs are difficult to measure and allocate to specific products because they are not directly related to the finished product.
• Indirect material costs are essential for the production process to occur but do not become part of the finished product.
• Indirect material costs are generally small in value compared to direct material costs but can still have a significant impact on the total cost of production.

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:

Overhead Allocation Formula:

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.

Differences between Direct and Indirect Material Costs:

Definition

Direct material cost is 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. On the other hand, indirect material cost is the cost of the materials used in the production or manufacturing process that cannot be directly traced or allocated to the end product.

Identification and Measurement:

Direct material costs are easy to identify and measure because they are directly related to the end product’s production process. Indirect material costs, on the other hand, are difficult to measure and allocate to specific products because they are not directly related to the finished product.

Tracing and Allocation:

Direct material costs can be traced and allocated to specific products, making it easier to determine the cost per unit of production. Indirect material costs, however, cannot be traced and allocated to specific products.

Value and Impact:

Direct material costs are typically high in value and can have a significant impact on the total cost of the finished product. Indirect material costs, on the other hand, are generally small in value compared to direct material costs but can still have a significant impact on the total cost of production.

Valuation of Materials

Valuation of materials refers to the process of determining the monetary value of materials held by an organization for production or manufacturing purposes. Accurate valuation is crucial for financial reporting, inventory management, and cost control. There are various methods used to value materials, and the appropriate method depends on the nature of the materials and the accounting policies followed by the organization. In this explanation, we will discuss some commonly used methods for the valuation of materials.

Historical Cost

The historical cost method values materials based on their original acquisition cost. It involves recording the materials at their actual cost when they were purchased or acquired. This method is simple and straightforward, and it provides a reliable measure of the cost incurred to acquire the materials. However, it does not account for any changes in the market value of the materials over time.

Weighted Average Cost

The weighted average cost method calculates the average cost of all the materials in stock based on their quantities and unit costs. It considers both old and new purchases and assigns a weighted average cost to each unit of material. This method is useful when there are frequent material purchases and the prices fluctuate over time. It smooths out the effects of price changes and provides a more balanced valuation of materials.

First-in, First-out (FIFO)

The FIFO method assumes that the materials purchased or produced first are the first to be used or sold. Under this method, the cost of materials is based on the price of the oldest inventory in stock. The remaining inventory is valued at the cost of the most recently purchased or produced materials. FIFO is suitable when there is a significant risk of material obsolescence or price inflation. It generally reflects the current replacement cost of materials more accurately.

Last-in, First-out (LIFO)

The LIFO method assumes that the materials purchased or produced most recently are the first to be used or sold. Unlike FIFO, LIFO values the materials based on the price of the most recent purchases or production. The older inventory is valued at the cost of the materials acquired earlier. LIFO is useful when there is inflation or rising material costs because it assigns higher costs to the remaining inventory, which can reduce reported profits and tax liabilities.

Standard Cost

The standard cost method values materials based on predetermined standard costs set by the organization. Standard costs are estimated costs per unit of material based on factors such as historical data, market prices, and management expectations. This method provides a benchmark for comparing actual costs and helps in identifying cost variances. It is commonly used in conjunction with variance analysis to monitor and control material costs.

Net Realizable Value (NRV)

The NRV method values materials at their estimated selling price minus the costs necessary to complete and sell the finished product. This method is typically used when the market value of the materials has declined or when there is evidence of impairment. NRV ensures that materials are not valued at a higher cost than they can be sold for, thus reflecting a more conservative valuation.