Introduction to Direct Materials
Direct Materials are the basic materials and supplies that are used up in the production of final products, and they can be directly identified in the final product. Direct materials are tangibly visible in the final product. It is directly related to the quantity of output (i.e.) Volume of input of direct materials is directly proportional to the output of the final product. Direct materials are listed down in the bill of materials of the final product. It is one of the variable costs included in the production process.
Direct materials include even the scrap and spoilage during the production process. Scrap is the material left out after the production process which possesses some value as the same can be sold based on the needs and requirements. Spoilage refers to the goods damaged in the production process.
Direct materials contrast to indirect materials. Indirect material acts as a support in the production process of the final product. (Eg – Oil, grease used in the running of machinery for the production process). Therefore, indirect material is considered to the incidental item used in the production of the final product.
- The wood used in making doors.
- The glass used in making bulbs.
- The steel used in Automobiles.
- Yarn used in making fabric/ cloth.
- The leather used in making shoes.
- The plastic used in toy making.
Reporting of Direct Materials in Financial Statements
- If direct materials are procured but yet to be used in the production process, then the same qualifies as Raw materials inventory.
- If the same is used in the production process, but the output/ final product is yet to be obtained from the production process then the same qualifies as work in progress.
- If the same is used in the production process, and the final output is yet to be sold then the cost of direct materials will form part of the finished goods inventory.
- If the same is used in the production process, and the final output is sold then the cost of direct materials will form part of the Cost of goods sold.
Direct Materials Cost
Direct material cost is the cost of raw materials and components that are used in the production process. It is the main component of the total cost of the product along with direct labor cost and production overheads.
It is a variable cost as the cost varies based on per unit of material input. It is volatile as the price of direct material changes in the market based on demand and supply and also the production efficiency determines the units consumed in production. Considering the uncertainties and variable nature of the direct material cost the management uses the standard costing system in order to have anticipated or expected the cost of production, and any variance from the standard costing needs to be monitored as it affects the top line and bottom line of the business.
Example of Cost on The Financial Statements
ABC Corp is in the business of toy making. It produces 100 units of toys per month. Per unit product cost is $10.
Direct labor and production overheads are $800. The selling price of a toy is $20.
- When the material is procured it goes to raw material inventory. So the valuation of inventory will be 100 units * $10 = $1000.
- When the 50 units of material are consumed in the production process and the output is yet to be received then the cost of materials consumed goes to work to progress. (i.e.) 50 units *$10 = $500.
- When the goods are produced and yet to be sold then the valuation of finished goods will be = Direct materials (+) Direct labor and production overheads = $1000+$800 = $1800 for 100 units of finished goods = $18 per unit of a toy.
- When the toys are sold then the sales will be $2000 (100 units * $20 per toy selling price). Cost of goods sold will be $1800 (Material, labor, and overheads). The profitability will be $200 for ABC Corp.
Variances in Direct Materials
Variances in Direct Materials are:
1. Material Yield Variance
This variance indicates the difference between the standard quantity of materials used in the production process, and the actual quantity used. This shows the actual yield from the production process in comparison to the standard operational levels. This indicates the efficiency of the production team.
2. Purchase Price Variance
This variance indicates the difference between the standard cost per unit of material, and the actual cost paid to procure per unit of material. This indicates the effective price paid to procure the goods, and how far it varies from the standard cost and how it affects the cost of the goods. This indicates the efficiency of the purchase team / Supply chain management.
These variances are calculated so that the management can know the bottlenecks in the business, which causes inefficiency and where the focus needs to be there in order to improve the top line, and bottom line.
X corp produces T-shirts. The Standard Qty is 100 units and the standard price is $5.00 per unit. The actual quantity used is 130 units, and the actual cost price is $4.00 per unit.
1. Material Yield Variance
Standard Quantity – Actual Quantity * Standard price
- Material Yield Variance = 100 – 130 * $5.00
- Material Yield Variance = $150.00
There is an unfavorable material yield variance of $150. This indicates that 130 units of direct materials are used in producing 100 units of the final product. This is due to inefficiency in production which is because of scrap and spoilage.
2. Purchase Price Variance
Actual Price – Standard Price * Standard Quantity
- Purchase Price Variance = $4 – $5 * 100 units
- Purchase Price Variance = $100
There is a favorable purchase price variance of $100. This indicates the pricing is effective, and the procurement cost is less than the standard cost. The overall direct material variance is unfavorable at $50. Though the price is effective the production process is not efficient. So the management has to consider the ideal steps in improving the production process.
Direct Materials are the most important element in the production, as it converts into the finished goods. Costing for the same is the prime thing as it contributes to the major part of the production cost. It has to be tracked regularly and its variances from the standard cost need to be analyzed by the management and any unfavorable variance need to be taken care of as if it affects the profitability of the business.
This is a guide to Direct Materials. Here we discuss Variances in Direct Materials and Direct Materials Cost along with Examples and Reporting of Direct Materials in Financial Statements. You may also look at the following articles to learn more –
- Hard Cost vs Soft Cost
- Examples of Operating Ratio
- Advantages and Disadvantages of GPR
- How to Calculate Indirect Costs