Are Indirect Materials a Product Cost?
Learn how essential, non-direct production expenses are accounted for in the overall cost of creating manufactured items.
Cost accounting provides a framework for tracking and analyzing expenses related to production. Accurately classifying these costs helps companies determine the true expense of creating their products. This article will clarify whether indirect materials are considered a product cost, exploring how different types of expenditures contribute to the final cost of manufactured goods.
Understanding Product Costs
Product costs, also known as inventoriable costs, represent all expenses directly tied to the creation of goods or services. These costs are recorded as an asset on a company’s balance sheet within inventory until the corresponding products are sold. When the products are sold, these costs then move to the income statement as Cost of Goods Sold (COGS), impacting reported profits.
Product costs typically comprise three main components that are aggregated during the manufacturing process. Direct materials are the primary raw materials that become a physical part of the finished product and can be directly traced to it. For example, the lumber used to build a wooden table or the fabric for a shirt are direct materials.
Direct labor refers to the wages paid to workers who physically transform raw materials into finished goods. Assembly line workers or machine operators whose time is directly spent on production activities represent direct labor.
Manufacturing Overhead (MOH) includes all other costs incurred in the factory that are not direct materials or direct labor. This broad category encompasses a variety of expenses necessary for production, such as indirect materials, indirect labor, and other factory operating costs. While not directly traceable to individual units, these costs are still essential for the manufacturing process to occur.
Understanding Indirect Materials
Indirect materials are items used in the production process that are necessary but cannot be easily or cost-effectively traced to specific individual products. Their cost per unit is often very small, making it impractical to track them precisely for each item manufactured. These materials are consumed during production but do not become a significant or identifiable part of the final product.
Examples of indirect materials include lubricants for factory machinery, cleaning supplies used to maintain the production facility, or small quantities of glue and nails in a furniture factory. Sandpaper used in finishing a product, or tiny screws and bolts for assembling electronics, also fall into this category. The effort and expense required to track the exact amount of glue or a single screw used in one specific chair or device would far outweigh the benefit. Therefore, they are grouped with other general factory expenses rather than being assigned directly to products.
How Indirect Materials Become Product Costs
Indirect materials are indeed a product cost, despite not being directly traceable to individual units. They are incorporated into the cost of a product through Manufacturing Overhead (MOH). This means that while they don’t appear as a direct material line item on a product’s cost sheet, their expense is still fully absorbed by the products manufactured.
Manufacturing overhead costs, including indirect materials, are accumulated over a period, such as a month or a quarter. These accumulated costs are then allocated to the products that were manufactured during that same period. Companies use an allocation base, such as direct labor hours, machine hours, or units produced, to distribute the total overhead costs among the products. For instance, if a company uses direct labor hours as its allocation base, a portion of the total indirect material cost is assigned to each product based on the labor time spent on it.
This allocation process ensures that all costs incurred in the factory, including those that are indirect, are fully accounted for in the cost of the finished goods. Although indirect materials are not physically part of the final product in a significant way, they are indispensable for the manufacturing process to function. Without lubricants, machinery might fail; without cleaning supplies, the factory environment could become unsafe or inefficient.
Therefore, including indirect materials as part of manufacturing overhead ensures that the total cost of manufacturing a product is accurately represented. This comprehensive product cost, encompassing direct materials, direct labor, and manufacturing overhead (which includes indirect materials), is crucial for accurate inventory valuation on the balance sheet. It also directly impacts the Cost of Goods Sold reported on the income statement, influencing a company’s reported profitability and taxable income.