Direct Material

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Blog Author :

WallStreetMojo Team

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya, CFA, FRM

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Direct Material Definition

Direct material refers to the raw materials that are directly used in the production process of goods and services of a company and are an essential component of the finished goods manufactured. Direct Material Costs are reported in the trading account debit side under the head “cost of goods sold.” They are also referred to as the expenditures incurred to make a product that can trace back to its original form.

It can be in physical form or artificial form like technology. E.g., In a company like Amazon, the main cost of the company is to build a system so that it can reach the maximum number of people across the globe. Here the technology cost will be looked at as the direct materials since, without setting up a proper technical infrastructure, the company will not be in a position to sell the products on the platform. On the other hand, cost accountancy, is more studied in detail since it directly impacts the final product costing.

Table of contents

Table of contents
Direct-Material

Types

They are broadly divided into the following categories.

Direct-Material-Types
  • Raw Materials: Raw Materials are the base materials used in the manufacturing process to make the finished goods.
  • Work in Process: WIP refers to the direct materials used in the process which are under unfinished form and require additional processing to turn them into a finished product.
  • Finished Goods: These are the goods ready for consumption or sales.

Examples of Direct Material

  • Example 1: In the case of a computer, it is made up of many parts like a keyboard, hard disk, motherboard, etc. All these form a part of the direct materials required to manufacture a computer.
  • Example 2: In the case of a textile company, yarn works as a raw material to process the same into a finished product like a cloth, which is then used to make clothes.
  • Example 3: In the case of a brick manufacturing company, cement is the primary direct material required to make the brick used in the construction of buildings.
  • Example 4: In the case of a real estate company, the direct material cost required to build the building is the purchase of cement, steel, etc., which is essential to start the construction work. Any change in the prices of these essential commodities may inflate the selling price of the flats as these costs are directly related to the project and cannot be avoided under any circumstances.
  • Example 5: In the case of Apple, the chip used inside the phone would be the essential material cost for the company to make the phone.
  • Example 6: In the case of a medicine company, the bulk drug used in the product acts as a direct material, which is essential to manufacture the medicine for the general public.

Advantages

  • They form an essential component of product costing, and without direct raw materials, no product can be manufactured.
  • Very useful in the contribution analysis of a product computed by revenue minus the cost of goods sold to arrive at the gross profit margin.
  • They are easily traceable since they are the main component of manufacturing a particular product.
  • Plays a significant part in the budget prepared for the future;
  • Is the deciding factor in computing the major ratios used for the management for analysis;

Disadvantages

The cost cannot be avoided since it forms the crust of the manufactured product, and an increase in the direct materials and costing eventually ends up in an increase in the price of the goods sold.

  • A company that relies heavily on the procurement of direct materials for its final product may struggle a bit if there is an issue with the materials to be procured.
  • Direct Costs are often exposed to huge fluctuations, which have an impact on the factory overheads as well.

Conclusion

Direct materials form a very crucial element of the product costing of the company since even a minor change in it may result in a massive financial impact on the profit and loss of the company. The cost cannot be avoided and is often used in standard costing or process-costing methodologies to arrive at the effective cost of the product so that the company can fix up the selling price. If the cost is too high, it may suggest improvements to curb it.