Direct Materials Cost Definition
Direct materials costs are costs of any raw material, component, or stock item that is used to manufacture a product.
These costs can be calculated by adding up the cost of all components and dividing by the number of units produced.
Components of the Direct Materials Cost
Here are the 5 main components of direct material cost:
1) Raw Materials Costs
Raw materials are the basic material that is used to create a product.
These can be plastics, metals, or even adhesives, for example. They need to have been transformed from their original state for them to become part of your product, and therefore they incur costs when they’re being produced into something else.
2) Packaging and Container Charges
Packaging is an essential part of the production process, as it goes beyond protecting your product and helps to promote them.
The costs associated with packaging vary according to size and material used but could range from $0.25 for a small pouch up to $20+ for something like a gift box.
3) Freight & Storage Charges
Transportation costs are associated with moving goods from one place to another.
This could be transporting them by air, sea, or ground transportation. You must include this in your calculations as these charges can increase quickly depending on your suppliers’ location.
Freight rates vary according to where they’re being transported, so it’s important that you find out what your supplier is charging.
These storage costs can quickly accumulate if you have a large inventory, so it’s important to keep an eye on it.
4) Indirect Tax
Indirect tax, or taxes applied to all products equally, includes things like GST and VAT.
The cost of indirect taxes should be included in your calculation, but you need to ensure that it is consistent with the rate at which these taxes are charged within your country’s legislation.
This will vary depending on where you’re located, so it’s important that you include this in your calculations.
Discounts are applied to reduce the price of a product and can be taken as either an upfront discount or as a promotional offer.
These discounts should not include anything that is given over and above what would normally be expected, such as free shipping, but instead focus on asking if you’ve received any special offers from your supplier, which will help you reduce your costs.
If you’re working with a distributor, they may be offering discounts to get the product into retail stores, for example. This can also help you reduce your overall cost when calculating your direct materials price.
Calculation Example of the Direct Material Costs
Direct materials costs can be calculated by adding up the cost of all components.
For example, Company ABC has the following direct material costs for November 2020 based on the components mentioned above:
- The total cost of raw material purchased: $ 108,000
- Indirect taxes as mentioned in the invoice: $ 16,200
- Wages paid to the employees that are involved directly in the production activities of the company: $ 45,000
- Packing and container charges paid, as mentioned in the invoice: $ 1,000
- Freight inward paid: $750
All expenses mentioned for Company ABC will be included in the computation for direct material costs, except for wages paid.
Wages paid are related directly to manufacturing products and cannot form part of a larger category such as indirect materials.
So, the total direct material costs for Company ABC is $125,950.
Examples of Direct Materials
When it comes to understanding direct materials cost, there are a few examples of how this can be applied.
In particular, these give some great real-life insight into what is involved in calculating the direct material costs as well as showing you some examples directly from the manufacturing business itself:
- Fabric is a direct material that can be used for manufacturing clothing.
- All the tools and equipment used in production are considered part of the direct materials cost, including heavy machinery, oil drums, etc.
- Wood is another example of a direct material that can be used to make furniture and other wooden items.
- Gases used for welding are also direct materials in manufacturing.
- Electronic components such as resistors, switches, etc. are examples of other direct materials found within products or production lines.
Why Does Direct Materials Cost Matter?
The following are reasons why a company has to take into consideration the total price of each component mentioned above:
- Direct materials costs can make a significant difference to your overall product price, and as such, they’re worth considering when you set out the cost of manufacturing each item that goes into your final product.
- The direct material cost is an essential part of any manufacturing firm’s expenses. It helps them make sure they are not losing money on their products by being too expensive to produce or sell at a profit.
- It also tells the managers if their suppliers are giving them proper prices for materials that can be used to make the products.
- Managers can use this information to negotiate better prices with suppliers, which may help them lower expenses and reduce costs for their company.
- It tells managers whether they are making money on each product that goes out the door or if there’s a problem in production that needs attention.
- It also lets managers know if there is a need to improve the efficiency of their production or change suppliers.
- Finally, it provides information about how much revenue they generate with each product sold and allows them to make better business decisions related to expenses.
As you can see, it is important to calculate the direct materials cost for your company to make informed decisions about selling your products and how much money you are driving on each sale.
When managers understand what materials go into producing a product, they will be able to determine if the price of that item needs adjusting or if there is a problem with products that need to be addressed.
This will ultimately help you create better products at lower costs and establish long-term relationships with suppliers who can offer fair prices for materials used in production.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.