How to Calculate Direct Materials Cost?
Direct materials cost is the cost of direct material associated with a production unit. Direct material is also referred to as productive material.
Direct material cost fluctuates a lot from unstable purchasing conditions and unpredictable manufacturing controls. The manufacturing costs are uncertain as they are affected by production processes and purchases of raw materials. Businesses allocate the expected cost to an item using a standard costing system.
Direct materials form part of your business’s inventory. Calculating direct materials used demands that you know the actual materials consumed in production in a given period. With this knowledge, you can get the cost of inventory and work out the work-in-progress inventory.
Proper management of inventory could lead your business to a profitable or unprofitable trading period. The cost of inventory is an item in the cost of goods sold in an income statement. The cost of direct materials is used to calculate the turnover ratios and inventory costs used during a trading period.
Inventory directly affects the business’s financial statement: profit and loss account and the balance sheet.
How to Calculate the Cost of Direct Materials Used in Production
Direct material is the raw material that is directly used to produce an item. To calculate the cost of materials used, you get the sum of every direct material cost consumed in the accounting period. The account for direct materials incorporates the cost of materials used and not materials purchased to estimate the production cost.
Direct material used is tracked to ascertain the cost of manufacturing a product. Direct materials fall under variable costs. The sum of direct material, manufacturing overhead, and labor costs are equal to the production cost.
Production Cost = Direct Materials + manufacturing Overhead + Direct Labor
Estimating the direct material used helps a company to calculate the point of reordering (reorder level). This means more raw material needs to be bought for production at this level. Direct material is a recipe for the manufactured item as listed under the bill of materials.
Cost of Direct Material Used = Opening Direct Material Inventory + Direct Material Purchased – Closing Direct Material Inventory
- a) Calculating Opening Direct Materials Inventory
Opening direct material inventory is the stock of raw materials at the beginning of an accounting period. Raw material goes through three stages in a manufacturing process: direct material stock work-in-progress stock and finally finished goods inventory. When material moves from direct material inventory A/C, it’s termed as ‘used.’
The common inventory costing method is First-In-First-Out or FIFO. It’s the most standard in the beverage and food industry.
- b) Adding Direct Material Purchased
Direct material purchased during the trading period is added. To this, the shipping cost incurred by the company is included.
- c) Get the Closing Direct Material Inventory
At the end of the trading period, count the inventory left in the store. Use the FIFO method for the ending direct materials total cost formula.
- d) Formula for direct materials used
The direct material used formula is used to calculate both the quantity and cost of material used in production.
How to Calculate the Cost of Raw Materials Purchased
Calculating the cost of raw materials purchased in an accounting period helps determine the amount of money required to fund an ongoing working capital. It’s calculated as follows:
- Get a valuation of opening inventory. The value is obtained from the preceding accounting period balance sheet as the closing inventory.
- Ending inventory value – is the inventory on hand at the close of an accounting period. The value is disclosed on the balance sheet.
- Cost of goods sold – appears as an item in the income statement during the accounting period.
The cost of raw materials purchased can therefore be calculated as follows:
Raw Materials Purchased = (Ending Inventory – Beginning Inventory) + Cost of Goods Sold.
How to Calculate Direct Materials Purchased
A direct material purchases budget determines the quantity of material purchased within a production period. A budget helps you to focus on expenses and cash flow while accounting for revenue and income.
The direct materials budget apportions all costs – direct and indirect. It’s prepared carefully for the success of the business. If the costs aren’t accurately accounted for, it results in underestimating and overestimating the costs, which causes serious cash-flow problems.
In calculating the direct materials purchases budget, the following information is useful:
- The level of production – obtained from a production budget
- Direct materials inventory at the beginning of an accounting period is found in the preceding accounting period’s production budget.
- Ending direct material inventory – it’s the inventory at the close of the trading period.
- Direct materials going to production
- Cost of direct materials
A direct materials budget is a vital budgeting tool, especially for manufacturing businesses. When accurately drafted, it satisfies the budget.
Direct Material Cost per Unit
The cost per unit comes up when a business produces several identical items. The formulation is compared against the budgeted cost to determine the cost-effectiveness of a company in producing goods.
The cost per unit is the sum of fixed costs and variable costs divided by units produced.
Variable costs include direct materials and vary proportionally to the units produced. When the volume produced increases, the cost reduces due to such factors as greater volume discounts. Fixed costs remain constant no matter the number of items produced.
The Best Approach to Calculate Direct Materials Used
How to find the cost of direct materials used
- Choose one inventory costing method suitable for your business. Counting the stock of direct material at the end of a trading period is easy. It’s, however, tough to assign a value if purchased at different prices.
A standard costing system allows your company to run its operations without waiting for the actual cost order to act. The direct material used and the purchase price are estimated using the available information. After setting the budgeted cost for direct material, the company can plan for purchases and production.
The system requires the purchased direct material stock to be recorded at an estimated cost. The quantity of direct materials used and recorded at an estimated usage rate is then converted to standard cost.
Using standard costing to estimate direct materials helps the company plan future sales and profitability at assumed conditions.
A cost flow assumption as listed below will solve the problem.
- First-in First-out (FIFO)
- Last-in First-out (LIFO)
- Weighted average
Every cost flow assumption will give a different cost for direct material, which affects the tax bill and the contribution margin.
FIFO will produce high profits and more taxes. LIFO reduces the tax, but only a few businesses want to sell or use the newest stock before the old inventory is over.
When a company finds it hard to separate direct materials stock according to the date of purchase, the weighted average method is employed. Direct material can be tracked unit by unit using specific identification. It doesn’t work for certain materials and is time-consuming.
- Check for abnormal spoilage. Abnormal spoilage and intense loss of direct material abnormally increase the direct materials used during production.
Every unit of direct material doesn’t end in the final product. Spoilage and losses are always expected. Abnormal spoilage could result from untrained workers or faulty raw materials.
- Running a material quantity variance allows you to compare the expected and actual direct material used within a trading period. The analysis produces inefficiencies like abnormal spoilage.
The company defines the standard material quantity used for every job. In manufacturing, the unit cost is vital in calculating the final production cost as profit is directly affected. The quantity of material budgeted variance compared to the actual quantity used shows the variance impact on the final cost.
The following factors determine the efficiency of direct material variance:
- Identification: The direct material usage variance shows the difference in the quantity of material used in production compared to the budgeted quantity.
- If more material is consumed than budgeted, the result is unfavorable efficiency. A miscalculation when accounting for materials gives unfavorable efficiency variance.
- Using inferior materials as you try to save money affects direct materials variance. The low-quality material results in using more material for production, and the result is unfavorable variance.
- Spoilage of material, theft, and damage by workers’ insufficient training and errors results in unfavorable variance. Failure to supervise direct labor and alterations in production procedures, equipment failure, production line breakdown, and vital machine operation glitch destroying or spilling material, give unfavorable variance also.
Calculating opening work-in-progress (WIP) inventory cost determines the value of items in production that are not yet complete by the end of a trading period. WIP isn’t accounted for in raw materials, and neither can it be accounted for as a final product.
WIP is a current asset in manufacturing firms whose value falls under the inventory cost of production. The value of WIP is held in its account.
The most common ways of accounting for WIP manufacturers are LIFO and FIFO. Depending on the situation, either method has its pros or cons. FIFO is most natural as materials received first are used first in the production process.
Direct Materials Cost Formula
Let’s look at the following three methods: FIFO, LIFO, and Weighted Average.
FIFO (First-In First-Out)
Determining a stock’s value using the direct materials cost formula FIFO is a crucial part of accounting. Direct material cost per unit is determined to calculate profit on the sale. When a company is dealing with a large inventory, recording the cost per item is hard. It becomes possible if FIFO is employed as a method of valuing stock.
FIFO captures the direct material purchased first to be used first in the production process. The last direct material is recorded as stock on hand.
- At the start of a trading period, the stock on hand is recorded.
- The date and quantity of all the inventory purchased and each shipment during a trading period is recorded.
- Record all inventory units sold during the same period.
- The value of stock sold during the accounting period is calculated. Using FIFO, the opening stock at the start of the trading period and the first inventory shipments are used first in the production process.
- The ending direct materials total cost formula, FIFO, and the remaining inventory value are calculated.
The weighted average or process costing method of calculating the cost of direct material used in production has the following steps:
- The unit’s physical flow
- Identical units of production
- Cost per identical unit
- Determine costs to finished units and ending WIP stock
- Reconcile costs
LIFO (Last-In First-Out)
LIFO works the opposite of the FIFO method. LIFO assumes that the last inventory added to the stock is used first. This cost is applied to the cost of goods sold.
The LIFO accounting method is best during inflation. The expensive units are used first. To get the cost of goods sold, you use the cost of the latest inventory.
Application of Linearity Assumption to Calculate Direct Material Cost
In linear relationships, a change in the value of an item directly affects the other. The price of a product and the cost of the material is linear.
Changes in the cost of the material affect the price of an item. When the relationship between some variables and the cost is linear, an equation is developed to calculate costs in the future based on related variables.
The cost of materials and labor influences the cost of production. An equation for calculating the cost of production using specified values for materials and labor costs is derived.
The equation helps to project future costs of production under various scenarios.
Perfectly linear cost-variable relationships are very few. But when the relationship is approximately linear, the least-squares regression line is calculated. The line best approximates the relationship between the variables.
A linear function for estimating costs could give incorrect values. For accurate estimates in financial decisions, businesses use many approximation methods for estimating costs.
There are no Generally Accepted Accounting Principles for doing a cost report for a process. Various ways of presenting the information with similar results are used.