Materials cost

What Is Materials Cost?

Materials cost refers to the expense incurred by a business to acquire and utilize the physical inputs necessary for the creation of goods or the provision of services. It represents a significant component of a product's total production cost and falls under the broader financial category of cost accounting. This cost encompasses the expense of obtaining, storing, and consuming raw materials and components throughout the production process. Understanding and managing materials cost is crucial for assessing a company's financial health and determining its profitability.⁴², ⁴³, ⁴⁴

History and Origin

While the precise "origin" of materials cost as a concept is tied to the very act of production, its formalization within accounting practices evolved with the rise of industrialization. As businesses grew in complexity and scale, particularly during the Industrial Revolution, the need for systematic methods to track and control expenses became paramount. Early cost accounting practices began to distinguish between various types of expenditures, with materials representing a primary and often dominant direct cost of production. The consistent need to manage the acquisition and consumption of physical inputs has made materials cost a foundational element of managerial accounting for centuries.

Key Takeaways

• Materials cost is the direct expense of raw materials and components used in manufacturing or service delivery.⁴¹
• It directly impacts a company's profitability and pricing strategies.³⁹, ⁴⁰
• Effective management of materials cost is vital for efficient production and competitive advantage.³⁷, ³⁸
• Materials costs are typically categorized into direct materials and indirect materials.³⁵, ³⁶
• Accurate calculation involves considering purchase price, transportation, and handling charges.³³, ³⁴

Formula and Calculation

The basic calculation of materials cost for a product or a period involves identifying the quantity of materials consumed and their unit price. For direct materials used in a given accounting period, the calculation often follows the formula for cost of goods sold, but applied specifically to materials:

Alternatively, for a specific product, the materials cost is determined by:

For example, if a company uses 10 units of a specific raw material that costs $50 per unit, the materials cost for that component would be $500.³² This calculation forms a critical input for determining the overall cost of goods sold. When managing inventory, various costing methods like First-In, First-Out (FIFO) or Weighted Average may be applied to assign costs to materials consumed.³¹

Interpreting the Materials Cost

Interpreting materials cost involves understanding its relationship to total production expenses and its impact on a company's financial performance. A high materials cost relative to the selling price can indicate lower profit margins, while efficient cost control can lead to increased profitability. Businesses analyze materials cost to make informed decisions about pricing strategies, budgeting, and resource allocation. For instance, in many manufacturing industries, materials can account for 60% to 70% of the total production cost, highlighting its significant influence.²⁹, ³⁰ Monitoring this expense helps companies identify opportunities for cost savings and improve overall efficiency of their production process.²⁸

Hypothetical Example

Consider "Alpha Furniture Co.," a manufacturer of wooden chairs. To produce one chair, Alpha Furniture Co. uses:

• 20 board feet of lumber at $3 per board foot
• 1 pound of screws at $5 per pound
• 0.5 gallons of wood stain at $10 per gallon

To calculate the direct materials cost for one chair:

• Lumber cost: (20 \text{ board feet} \times $3/\text{board foot} = $60)
• Screws cost: (1 \text{ pound} \times $5/\text{pound} = $5)
• Wood stain cost: (0.5 \text{ gallon} \times $10/\text{gallon} = $5)

The total direct materials cost per chair for Alpha Furniture Co. would be ( $60 + $5 + $5 = $70 ). This figure is essential for Alpha Furniture Co. to establish its selling price and manage its supply chain.

Practical Applications

Materials cost is a fundamental metric across various financial disciplines, particularly in cost accounting and managerial finance. In manufacturing, it is a primary input for determining the cost of goods sold and plays a critical role in setting competitive pricing strategies.²⁶, ²⁷ Businesses regularly analyze materials cost to identify areas for cost control, such as negotiating better prices with suppliers or implementing lean manufacturing principles to reduce waste.²⁴, ²⁵

Furthermore, fluctuating materials costs can significantly impact a company's financial health. For example, the U.S. Bureau of Labor Statistics publishes the Producer Price Index (PPI), which tracks changes in commodity prices, directly affecting the cost of raw materials for businesses²², ²³. During periods of significant supply chain disruptions, such as those observed in recent years, material availability and pricing can become highly volatile, impacting production schedules and profitability.²⁰, ²¹ The Federal Reserve also analyzes how supply chain pressures influence inflation measurements, which directly ties into the actual costs businesses face for their materials.¹⁸, ¹⁹

Limitations and Criticisms

While essential, relying solely on basic materials cost figures can present limitations. One challenge lies in accurately allocating indirect costs associated with materials, such as purchasing department salaries or warehouse rent, which are typically classified as manufacturing overhead rather than direct materials.¹⁵, ¹⁶, ¹⁷ Another complexity arises from price volatility in global commodity markets, which can make long-term budgeting and forecasting of materials cost difficult. Companies must account for potential material cost variances, which measure the difference between actual and standard material usage or purchase prices.¹⁴ These variances can indicate inefficiencies in the production process or unexpected market changes. Additionally, the chosen inventory valuation method (e.g., FIFO, LIFO, Weighted Average) can influence the reported materials cost, affecting reported profitability and working capital, even if the physical flow of goods is the same.¹³

Materials Cost vs. Direct Labor Cost

Materials cost and direct labor cost are two distinct yet equally critical components of a product's prime costs. Materials cost refers specifically to the expense of the physical raw materials and components that are directly incorporated into the finished product. For example, the cost of wood for a furniture maker or flour for a bakery.¹¹, ¹²

In contrast, direct labor cost represents the wages and benefits paid to employees who are directly involved in the manufacturing or production process, actively transforming raw materials into finished goods.⁹, ¹⁰ This includes, for instance, the carpenters assembling furniture or the bakers mixing dough. While both are direct costs that can be directly traced to a specific product or service, materials cost relates to the tangible inputs, and direct labor cost relates to the human effort applied. Understanding the relative proportions of each, especially in industries like construction where materials often account for a larger percentage of total project expenses than labor, is crucial for accurate financial analysis.⁸

FAQs

What is the primary purpose of tracking materials cost?

The primary purpose of tracking materials cost is to understand and control the expenses associated with the raw materials and components used in production. This knowledge helps businesses determine product pricing, assess profitability, and make informed decisions about purchasing and inventory management.⁶, ⁷

How do supply chain issues affect materials cost?

Supply chain issues, such as disruptions in transportation or shortages of raw materials, can significantly increase materials cost due to reduced availability and higher demand. These issues can lead to price volatility and impact a company's ability to maintain stable production.⁵

Are shipping costs included in materials cost?

Yes, shipping costs and other charges incurred to bring materials into a usable condition, such as transportation, handling, and sometimes even taxes or import duties, are typically included in the overall materials cost. This ensures a comprehensive calculation of the total cost of acquiring the material.³, ⁴

What is the difference between direct and indirect materials cost?

Direct materials cost refers to the cost of raw materials and components that can be directly and easily traced to a specific finished product, like the fabric for a dress. Indirect materials cost, on the other hand, refers to materials used in the production process but not directly part of the final product or not easily traceable to it, such as cleaning supplies or lubricants for machinery. Indirect materials are usually categorized under manufacturing overhead.¹, ²