What it means
A manufactured product is made from things that were bought. The materials that end up in the product, or are consumed specifically in making it, are direct materials; the materials consumed in running the factory generally, such as lubricants, cleaning supplies and small tools, are indirect materials and are treated as overhead.
The distinction is one of traceability: direct materials can be measured for each unit or batch and charged to it without allocation. A bill of materials lists the direct materials for a product, their quantities and specifications, and it is the starting point for costing, purchasing, production planning and inventory control.
The cost of direct materials is the cost of getting them to the point of use, not just the supplier's price. It includes freight, insurance in transit, import duties and non-recoverable taxes, and handling into store, and it is net of trade discounts and rebates.
This landed cost is what should be used for product costing and for comparing suppliers, since a cheaper unit price from a distant supplier may be dearer once freight and duty are added. Where prices change during a period, the cost charged to production depends on the inventory valuation method: first-in-first-out, weighted average, or standard cost with variances.
Usage is the other half of the cost. The quantity of material in a unit of product is rarely the quantity that must be bought for it: cutting produces offcuts, machining produces swarf, processes have yields below 100%, some units are scrapped, and some material is lost in handling.
A well-set standard for material usage includes a normal allowance for these losses, so that the standard quantity is what an efficient process should consume, and abnormal losses beyond it are reported as variances and investigated. Reducing normal losses, through better cutting patterns, tighter process control, supplier quality or design changes, reduces material cost per unit without changing the price of anything.
Standard costing makes the control explicit. Each product has a standard material cost, the standard quantity multiplied by the standard price, and actual cost is compared with it through two variances.
The price variance measures the effect of paying more or less than standard, caused by market movements, supplier changes, quantity discounts or exchange rates, and it is usually the purchasing department's responsibility. The usage variance measures the effect of consuming more or less than standard, caused by scrap, rework, yield, substitution or theft, and it is usually production's responsibility.
Separating the two directs the investigation to the right place; a total variance alone starts an argument between purchasing and production. Direct materials matter to the finance function in several ways beyond product cost.
They are the main component of raw material and work-in-progress inventory, so their valuation and their physical control affect the balance sheet and the risk of loss. Their price exposure is a major risk for manufacturers, managed through contracts, hedging and pass-through pricing.
Their share of cost determines how much a price rise or a design change affects margin. And in make-or-buy, sourcing and product design decisions, the direct material cost is usually the largest and most reliable number on the table.
In practice
Real-world examples.
Example
A bakery's direct materials are flour, yeast, salt, water and packaging, costed per batch from the recipe and compared with actual stores issues to find over-portioning and waste.
Example
A phone maker's bill of materials lists 200 components with a total landed cost of $180, and a 10% rise in the price of the display module adds $4 to the cost of every unit.
Example
A steel fabricator sets its standard plate usage at 112% of the net weight in the drawings to allow for cutting and offcuts, and reports any usage above that as a variance.
Think of it
“Direct materials are the raw ingredients that go into your product-what physically becomes the finished goods.
Formula
Calculation
Direct material cost per unit = Sum over materials of (Standard quantity per unit x Landed cost per unit of material)
Landed cost per unit of material = Purchase price + Freight + Duty + Handling minus Discounts
Standard quantity = Net quantity in the product / (1 minus Normal loss percentage)
Material price variance = (Actual price minus Standard price) x Actual quantity purchased or used
Material usage variance = (Actual quantity used minus Standard quantity for actual output) x Standard price
Worked example: costing. A dining chair contains 2.2 metres of timber net, with a normal cutting loss of 8%, and 1.5 metres of upholstery fabric. Timber is bought at $4.60 a metre plus $0.25 freight and $0.15 duty; fabric at $4.00 a metre delivered.
- Landed cost of timber = $4.60 + $0.25 + $0.15 = $5.00 a metre
- Standard timber quantity = 2.2 / (1 minus 0.08) = 2.39, set at 2.4 metres
- Direct materials per chair = 2.4 x $5.00 + 1.5 x $4.00 = $12.00 + $6.00 = $18.00
Worked example: variances. The standard timber cost is 2.4 metres at $5.00, $12.00 a chair. In a month the factory made 10,000 chairs and used 25,200 metres of timber bought at $5.20 a metre.
- Standard cost of timber for output = 10,000 x 2.4 x $5.00 = $120,000
- Actual cost = 25,200 x $5.20 = $131,040
- Price variance = ($5.20 minus $5.00) x 25,200 = $5,040 adverse (the supplier raised prices)
- Usage variance = (25,200 minus 24,000) x $5.00 = $6,000 adverse (1,200 metres more than standard, traced to a new cutting operator and a batch of warped boards)
- Total variance = $11,040 adverse, reconciling $120,000 to $131,040
Worked example: exposure. Direct materials are 45% of a manufacturer's $22,000,000 cost of sales, about $10,000,000. A 3% rise in material prices that cannot be passed on costs $300,000 a year, which on an operating profit of $2,000,000 is a 15% reduction. A design change that cuts material content by 5% saves $500,000.Case study
Seen in the real world.
A bakery chain with revenue of $8,000,000 spent about 32% of it, $2,560,000, on direct materials, mainly flour, butter, sugar, eggs and packaging. The finance manager noticed that the material cost percentage had crept up from 30% to 32% over two years with no change in recipes or prices that could explain it, and calculated that the drift was costing about $160,000 a year. The purchasing manager's records showed prices in line with contracts, so the price variance was nil; the problem was usage.
A usage analysis by product and site compared the ingredients issued from stores with the standard quantities for the units actually baked. It found a usage variance of about 6% adverse, $154,000 a year, concentrated in three areas. Portioning was by eye rather than by weight at several sites, so loaves and pastries were consistently heavier than the recipe, a hidden gift to customers.
Two sites were over-ordering perishable ingredients and throwing away the surplus. And at one site, stock records showed butter usage 20% above any plausible recipe requirement, which turned out to be theft.
The chain introduced digital scales with recipe programmes at every site, so that portions matched the standard; changed perishable ordering to a daily forecast; and tightened stores controls at the site with the butter problem. Within six months the usage variance had fallen to under 1%, saving about $120,000 a year, and the material cost percentage was back at 30%. The finance manager's report to the owners noted that the price of every ingredient had been correct throughout; the chain had simply been using more of them than its products required, and had only found out by comparing what went out of the stores with what should have.
Watch out
Common mistakes.
- Costing materials at the supplier's unit price without freight, duty and handling, which understates product cost and can make a distant supplier look cheaper than it is.
- Setting standard quantities at the net content of the product with no allowance for normal loss, so that every period shows an adverse usage variance that nobody investigates because it is always there.
- Reporting a single total material variance, which starts an argument between purchasing and production instead of directing each to the part it controls.
Questions
People also ask.
What is the difference between direct materials and indirect materials?
Direct materials become part of the product or are consumed specifically for it and can be traced to it; indirect materials, such as lubricants, cleaning supplies and small tools, are consumed in running the factory generally and are treated as overhead.
What is the difference between direct materials and raw materials?
Raw materials is an inventory category: materials bought but not yet used. Direct materials is a cost category: the material cost traced to products. Raw materials become direct material cost when they are issued to production, and indirect material cost when they are consumed as overhead.
How do material variances help?
They separate the effect of price, which purchasing controls, from the effect of usage, which production controls, and they show where the actual cost of a period's output differed from what it should have been, so that the cause can be found and fixed.
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