Definition and Explanation
Direct material cost
A direct material is any commodity that enters into and becomes a constituent element of a product. Thus cotton is a direct material for textile goods, leather for shoes, wood (or steel or plastic) for furniture, etc. Some products have more than one direct material, e.g. biscuits are made of not only flour but also sugar, milk, oils, etc. Another name for direct materials is raw materials.
To determine the cost of direct materials used in a specific year, the value of unused raw materials in store at the beginning of the year (opening stock) should be added to the value of the raw materials bought during the year and from the total so derived should be deducted the value of unused raw materials at the end of the year (closing stock). It can be shown as follows:
If any carriage costs are incurred on purchases of raw material such costs should be added to the value of the materials bought in the year. And if any material is returned to suppliers (returns outwards), such returns should be deducted from the purchases figure to arrive at the net value of raw materials bought in the year.
If in the above example, we are told that carriage inwards expenses amounted to $17.400 and returns outwards to $5,900, the value of raw material used will be computed as follows:
Sometimes raw material is imported from another country and attracts such expenses as import duties, sea or air freight, marine insurance, clearing charges, etc. These import related expenses are added to the cost of raw material bought in the same manner as carriage inwards.
If a part of the imported raw material is not found\ satisfactory (or in excess of needs), it may be too expensive and inconvenient to return that part to the overseas supplier. Such material is often sold locally and the proceeds of such sale of raw material are deducted from the purchase price of material in the same manner as returns inwards are treated.
Indirect material cost
The indirect material refers to material which indirectly forms part of the finished product, it can not be directly charged to unit or order. Glue, nails, rivets and other such items are examples of indirect material. In order to calculate the unit cost of indirect material cost is divided by units manufactured.
The following figures were taken from the ledger of John Fertilisers Co. who imported raw materials:
The cost of raw material used by John Fertilisers Co. will be calculated as follows: