What Is Material Cost? Components and Calculations

Material cost represents a fundamental expense for businesses involved in producing goods. It encompasses expenditures directly tied to raw materials and components that become an integral part of a finished product. Understanding and effectively managing this cost is central to a company’s financial health and profitability. It forms a significant portion of overall production expenses, directly impacting pricing strategies and profit margins. Accurately accounting for material costs allows businesses to make informed decisions regarding procurement, production, and sales.

Defining Material Cost

Material cost refers to the direct expenses associated with raw materials and components physically integrated into the final product. Examples include steel in a car frame or fabric in clothing. These are “direct materials” because their cost can be directly traced to a specific unit of production.

It is important to distinguish direct materials from “indirect materials.” Indirect materials, such as lubricants for machinery or cleaning supplies used in a factory, are necessary for the production process but do not become part of the finished product itself. These indirect costs are typically categorized as manufacturing overhead, not as direct material cost. This distinction is crucial for accurate cost accounting, allowing businesses to precisely determine the cost of each product manufactured and to manage their expenses effectively.

Components of Material Cost

The total material cost of a product includes elements beyond the initial purchase price paid to the supplier. Other direct costs incurred to bring these materials to a usable condition at the business’s premises are also included.

These additional costs include:
Freight-in: Costs of transporting materials from the supplier to the manufacturing facility. This expense is added to the cost of inventory as it is necessary to acquire the materials.
Customs duties and import taxes: Levies paid on materials brought in from other countries.
Insurance costs: Incurred while materials are in transit to protect against loss or damage.
Handling and storage costs: Such as initial inspection or specialized storage required before materials enter production.
All these expenses are necessary to get the materials ready for use in production.

Calculating Material Cost

Determining the actual cost of materials used in production can be complex, especially when material prices fluctuate. Businesses employ various inventory valuation methods to assign costs to the materials consumed.

First-In, First-Out (FIFO)

The FIFO method assumes that the first materials purchased are the first ones used or sold. This method means that the cost of materials remaining in inventory reflects the most recent purchase prices, while the cost of goods sold reflects older costs.

Last-In, First-Out (LIFO)

The LIFO method assumes that the most recently purchased materials are the first ones used or sold. Under LIFO, the cost of goods sold reflects the most recent material costs, while older costs remain in inventory. While permitted under U.S. Generally Accepted Accounting Principles (GAAP), LIFO is generally not allowed under International Financial Reporting Standards (IFRS).

Weighted-Average Cost

The Weighted-Average Cost method calculates an average cost for all materials available for use by dividing the total cost of goods available for sale by the total number of units available. This average cost is then applied to both the materials used in production and the materials remaining in inventory, smoothing out price fluctuations.

Tracking and Managing Material Costs

Effective tracking and management of material costs are essential for operational efficiency and financial control.

Inventory Management Systems

Inventory management systems provide real-time data on material inflow, outflow, and current stock levels. These systems help businesses maintain optimal inventory levels, reducing the risk of stockouts or excessive holding costs.

Purchase Orders (POs)

Purchase orders are formal documents used to authorize and track material acquisitions. They detail the types, quantities, and agreed-upon prices of materials from suppliers, serving as a legal agreement once accepted. POs are crucial for ensuring that material purchases align with budget and operational needs.

Material Requisition Forms

Material requisition forms are internal documents that authorize the release of specific materials from storage for use in production. These forms ensure that materials are properly accounted for as they move from inventory to the manufacturing process, helping to allocate costs accurately to specific jobs or products.