Statements on Management Accounting

P R A C T I C E O F M A N A G E M E N T A C C O U N T I N G

C R E D I T S

T I T L E

The Institute of Management Accountants appreci-ates the contribution of Michael J. Sandretto, Price

Waterhouse & Co., Columbus, Ohio, for his researchand writing associated with this project.

Definition andMeasurement of Direct

Material Cost

Published byNational Association of Accountants10 Paragon DriveMontvale, NJ 07645www.imanet.org

Copyright © 1986 in the United States of America by National Association of Accountants.

All rights reserved

ISBN 0-86641-146-1

T A B L E O F C O N T E N T S

Definitions . . . . . . . . . . . . . . . . . . . . . . . . . 1

Materiality . . . . . . . . . . . . . . . . . . . . . . . . . 2

Material Quantities . . . . . . . . . . . . . . . . . . . 2

Material Lost in the Production Process . . . . 2

Samples, Prototypes, and InitialProduction Runs . . . . . . . . . . . . . . . . . . 3

Unit Price of Direct Material . . . . . . . . . . . . . 3

Use of Estimates . . . . . . . . . . . . . . . . . . . . 3

Material-Related Costs . . . . . . . . . . . . . . . . 4

Cost Systems . . . . . . . . . . . . . . . . . . . . . . . 4

The term “direct material cost” as used in prac-tice, in literature, and in litigation has a wide vari-ety of meanings. Unless the intended meaning ina given context is clear, confusion and misunder-standing are likely to result. The purpose of thisStatement is to provide a conceptual definitionof “direct material cost” that, in the absence ofa specified alternative, should be taken as themeaning of this term.

This Statement makes the conceptual definitionmore concrete by describing how direct materialcosts should be measured. Measurement hastwo aspects:

a. The quantity of material that is to be includedas direct material; that is, the inputs that areto be counted.

b. The unit price by which each of these quanti-ties is multiplied to arrive at a monetary cost.

Many of the examples used in this Statementrefer to the direct material cost of goods pro-duced in manufacturing companies. The exam-ples apply equally well to the same or similartransactions for projects, services, and othercost objects. The allocation of joint product orby-product costs is not addressed in thisStatement.

In a manufacturing company, direct material costis an element of inventory cost and of cost ofsales. Differences in how companies define thisterm result in variations in the amount recordedas direct material cost and the amount recordedas overhead or expense. Differences in the waymaterial costs are accounted for in cost-typecontracts, in projects, and for other cost objectsalso lead to differences in the amounts recordedas direct material cost and the amounts record-ed as overhead or expense. If users do notunderstand what items are included in direct

material cost in such situations, their interpreta-tion of the information may be erroneous, andthey may make unsound decisions.

DefinitionsDirect Material Cost—Quantities of material thatcan be specifically identified with a cost object inan economically feasible manner, priced at theunit price of direct material.

Cost Object—A product, contract, project, organi-zational subdivision, function, or other unit forwhich costs are measured or estimated.

Direct Cost—A cost that can be specifically iden-tified with a cost object in an economically feasi-ble manner.

Material Quantity—A physical amount of material,such as a pound of copper, a 50-gallon drum of achemical, or a batch of 100 semiconductors.

Scrap—Material residue from manufacturingoperations that has some value. Examples ofscrap include border material from stampingoperations, shavings, filings, borings, and turn-ings. Scrap may have relatively minor recoveryvalue, as in the case of steel, or it may be of sig-nificant value, as in the case of gold.

Waste—Material that is lost, evaporates, orshrinks in a manufacturing process or is aresidue that has no significant recovery value inexcess of its disposal costs.

Defective Units—Production that does not meetquality standards. Defective units may bereworked and sold, or they may be rejected anddisposed of for salvage value.

Material-Related Costs—Costs, other than directmaterial costs, that are incurred as a result of

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the acquisition, inspection, storage, or move-ment of direct material quantities.

Cost Item—A subdivision of cost, such as freight,duty, insurance, sales tax, or outside processingcosts.

Unit Price of Direct Material—Invoice price andacquisition-related cost items that can be specif-ically identified with direct material quantities inan economically feasible manner and that canbe measured with reasonable accuracy.

MaterialityIf a cost item is immaterial, it should be account-ed for in a manner that is economically feasible.

Material QuantitiesIf the cost object is the production of a manufac-tured or processed product, its direct materialcost normally should include quantities of mate-rial that become a physical part of the costobject and those materials that are consumed inthe manufacturing process that can be specifi-cally identified with that cost object.

If the cost object is the production of a service,its direct material cost normally should includeall quantities of material that can be specificallyidentified with producing the service.

If the cost object is the production of a project,its direct material cost normally should includeall quantities of material that can be specificallyidentified with the project. For a large project,direct material cost typically includes far morecategories of direct material quantities than in aproduct because it is relatively easy to identifyquantities of material specifically with a largeproject. Examples include fasteners, adhesives,lubricants, and other items whose unit costs aretoo low to be considered direct material costs for

many manufactured products. If a large project isbroken down into a series of smaller projects,products, or subassemblies, the material cate-gories listed in this paragraph typically are notincluded in the direct material cost of thesesubdivisions.

Costs classified as direct material costs must beexcluded from costs used in calculating over-head rates. For example, if one project is largeenough to include fasteners and lubricants indirect material quantities, but those items areincluded in overhead for other projects, the costof fasteners and lubricants should not be includ-ed in the overhead rate applied to the first proj-ect. It follows that entities that define directmaterial costs differently for different costobjects will have two or more overhead rates.

Material quantity should include the cost ofpackaging material to the extent it is included inthe finished product. Examples include bottlesfor liquor and perfume and containers for cos-metics and medical products.

Material quantity should include packing sup-plies necessary to deliver goods to customers,to the extent that the goods are packed withthese supplies as part of the productionprocess.

Material Lost in the Production ProcessDirect material cost should include the materialcost of scrap, waste, and normally anticipateddefective units that occur in the ordinary courseof the production process. The following exam-ples depict situations in which such costsshould be classified as direct material costs:

a. A part is stamped from a roll of strip steel, ora finished unit is produced by turning a cast-ing. The amount of material lost in these

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processes through ordinary scrap usually canbe predicted with reasonable accuracy. Thecost of the predicted scrap should be includ-ed in the direct material cost of the part.

b. A quantity is lost in the production processthrough evaporation, dehydration, spoilage,shrinkage, or similar causes. The amount ofmaterial that is lost in these processes usu-ally can be predicted with reasonable accura-cy. The cost of the predicted amount of lostmaterial should be included in the directmaterial cost.

c. Engineering estimates are developed for thepercentage of defective units expected from agiven production process, and they are rea-sonably accurate. The cost of material in theestimated percentage of defective unitsshould be included in the direct material costof completed production.

d. In most cases, the net salvage value of esti-mated scrap, waste, and defective unitsshould reduce the direct material cost. Thedirect material cost should be increased,however, if the related costs exceed the sal-vage value, as in the case of certain chemicalor nuclear wastes.

Unanticipated quantities of scrap, waste, ordefective units should not be included in directmaterial cost. These quantities should be includ-ed in manufacturing overhead or should beexpensed.

Samples, Prototypes, and Initial Production RunsRoutine quality assurance samples that are test-ed to destruction should be included in directmaterial cost. Nonroutine quality assurancesamples taken due to quality problems shouldnot be included in direct material cost.

The material cost of marketing samples and pro-

totypes should not be included in direct materialcost.

Unit Price of Direct MaterialThe unit price of direct material should includethe invoice price and other costs paid to vendorsto deliver the material quantity to the productionfacility or to a point of free delivery. The followingcosts are included in the unit price of directmaterial:

l Invoice price for direct material quantity,l Invoice price for outside processing,l Shipping costs (inward freight) paid or owed

to outside vendors,l Sales tax,l Duty, andl Cost of delivery containers and pallets, net of

return refunds.

Trade discounts, refunds, and rebates should bededucted in calculating the unit price of directmaterial.

If cash discounts offered by the vendor exceedreasonable interest rates, the price of directmaterial should be reduced by the excess.

Demurrage charges should not be included indirect material cost.

Royalty payments and licenses should be includ-ed in direct material cost if they are functions ofdirect material quantities used in producing thecost object.

Use of EstimatesEstimates of direct material quantities and unitprices may be used if they are sufficiently accu-rate to be considered “specifically identified”with a cost object. The following situations areexamples of estimates that are sufficiently accu-

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rate to be considered direct material costs inmost instances:

a. A manufacturing firm establishes standardmaterial quantities for its products, but itssystem does not trace variances to theseproducts. Nevertheless, there is a reason-able expectation that variances are propor-tional to the standard quantities and thusthat the actual material quantities are propor-tional to the standard quantities.

b. A manufacturing firm uses standard purchaseprices for its materials. Although standardpurchase prices are not necessarily the sameas actual purchase prices, the firm is able toassociate major deviations from standardpurchase prices with specific products orproduct lines.

c. Inward freight costs are added to direct mate-rial cost by a rate that approximates the actu-al cost, such as a percentage of price paid tothe vendor or a percentage of the weight perunit of cost.

Material-Related CostsCertain costs are closely related to the quantityof material acquired or used, but they cannot bespecifically identified with a cost object in aneconomically feasible manner. These indirectcosts are material-related costs. Material-relatedcosts should be allocated to cost objects on thebasis of some measure of direct material quan-tity or cost rather than on direct labor hours orcost. Costs for the following functions usuallyare considered material-related costs:

l Purchasing,l Receiving,l Receiving inspection,l Material storage costs prior to purchased

material entering production, andl Issuing costs for material initially entering the

production process.

Certain cost items may be closely related to mate-rial quantities and may be allocated to costobjects based on direct material quantities orcosts. They are, however, more closely related tothe production process than to the acquisition ofmaterial and are not typically considered material-related costs. Furthermore, they may be applica-ble to different time periods than the period inwhich the direct material cost was incurred.Examples of those cost items are:

l Material storage costs subsequent to enter-ing the production process,

l Issuing costs for material subsequent toentering the production process,

l Production planning and control costs, andl Internal transportation costs.

Cost SystemsThis Statement does not discuss standard costsystems in detail and does not address howstandards should be determined. In most cases,cost analysis and control are improved if thestandard material quantity includes normal scrapand waste as defined in this Statement butexcludes all lost or defective units. Differen-tiating between good units and normally antici-pated lost units helps focus management’sattention on lost units. Additionally, including indirect material the standard material quantity ofboth good units and normally anticipated lostunits helps focus management’s attention ontotal material cost.

The cost accounting systems of some firms, par-ticularly retail firms, include many material-related costs as direct material cost. In suchsystems, direct material is defined more broadlythan in this Statement. Nevertheless, if the rele-vant material-related costs are allocated on the

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basis of direct material, the resulting productcosts may be substantially the same under thisStatement as under a broader definition of directmaterial cost. The broader definition is useful forcertain management accounting purposes, how-ever, it should be recognized that direct materialcost as measured in such systems—and forother purposes—may be different from directmaterial cost as measured according to the con-cepts of this Statement.

The cost accounting systems of many firms allo-cate material-related costs on some measure ofdirect labor, as contrasted with a measure ofdirect material, as recommended by thisStatement. Allocation based on direct labor is, inmany cases, easier to compute. It is likely, how-ever, that allocation on some measure of directmaterial yields a more accurate measure of bothdirect and total cost of a cost object.

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