A small business guide to direct materials

I don’t believe people who say they don’t eat loose chocolate chips when making cookies. You might be threatening your ingredients supply for the next batch, but they’re utterly irresistible.

If you’re a chocolate chip pilferer like me, you know not to rely on the number of cookies you made to tell you how many chocolate chips are in the pantry. The same happens in manufacturing for less gourmandizing reasons. Let’s figure out how to find direct materials used in a business.

Overview: What are direct materials?

Direct materials are the building blocks of manufactured products. For example, eggs, milk, and bread are direct materials in the production of French toast.

Businesses track direct material usage to estimate how much it costs to manufacture products. Direct materials are variable costs, moving in lockstep with production. Add direct material to direct labor and manufacturing overhead, and you have a manufactured good’s product cost.

Product Cost = Direct Materials + Direct Labor + Manufacturing Overhead

Tracking direct material usage also helps businesses determine the reorder point, or the inventory level at which they need to buy more raw materials to keep up with production. Companies list a product’s direct materials on a bill of materials, which is like a recipe for manufactured goods.

How to calculate direct materials used

Say you own a coffee shop and want to calculate the quantity and cost of coffee beans used in February. Let’s figure it out with the direct materials used formula:

Beginning DM Inventory + DM Purchases – Ending DM Inventory = Direct Material Used

1. Calculate beginning direct materials inventory

Beginning direct material inventory refers to the unused raw material at the start of the month or year.

Raw materials flow through three phases in the manufacturing process: direct material inventory to work-in-process inventory to finished goods inventory. Once the material leaves the direct material inventory account, it’s considered “used” for this calculation.

If this is your first time calculating direct material costs, you may be stumped figuring out how to put a dollar amount on your direct materials inventory. Choose from one of four inventory costing methods. I’ll use the first-in, first-out (FIFO) method, standard in the food and beverage industry.

On Feb. 1, your coffee shop has the following as its beginning inventory.

Dec. 5, 202050 pounds$12$600
Jan.10, 202150 pounds$15$750
Jan. 24, 2021100 pounds$10$1,000

Direct material inventory starts at 200 pounds, costing $2,350.

2. Add direct material purchases

Add direct material purchases made during the month. Include the shipping costs your business incurred in the calculation, called freight in.

The coffee shop purchased another 100 pounds at $11 per pound on Feb. 15, with free shipping to boot. Direct material purchases in February are $1,100.

3. Determine ending direct material inventory

At the end of the month, count how much inventory you have left.

The coffee bean scale reads 225 pounds on Feb. 28. Since the coffee shop uses the FIFO inventory costing method, we can assume that the leftover coffee beans are from the most recent inventory purchases.

Under the FIFO method, ending inventory will be made up of:

• 100 pounds purchased on Feb. 15 at $11 per pound, totaling $1,100

• 100 pounds purchased on Jan. 24 at $10 per pound, totaling $1,000

• 25 pounds purchased on Jan. 10 at $15 per pound, totaling $375

The ending direct material inventory balance is $2,475 ($1,100 + $1,000 + $375).

4. Calculate direct material used

We now have all the numbers needed to calculate the direct material used in production. You can dual purpose the direct material used formula to calculate both the cost and quantity used in production.

200 pounds beginning + 100 pounds purchased – 225 pounds ending = 75 pounds used

$2,350 beginning + $1,100 purchased – $2,475 ending = $975 used

3 best practices when calculating direct materials use

Here’s how to put your direct material usage calculator into action.

1. Choose an inventory costing method that fits your production

While drudging, it’s easy to count your direct materials inventory at month-end. However, assigning a value to an inventory of identical products you purchased at fluctuating prices is nearly impossible.

The solution is identifying a cost flow assumption that works for your business. Your options are:

• First-in/first-out (FIFO)

• Last-in/first-out (LIFO)

• Weighted average

Each cost flow assumption will produce a different direct materials cost, which will affect your contribution margin and tax bill. Chat with an accountant to discuss which method makes the most sense for your business.

Usually, FIFO produces higher profits, meaning more taxes. The LIFO method can help you defer taxes, but very few businesses sell their newest inventory before clearing out older inventory. Businesses employ the weighted average method when they can’t easily separate their stock according to purchase date.

You may also track direct material item by item using specific identification, though it’s time-consuming and unworkable for some materials.

2. Look out for abnormal spoilage

The excessive loss of direct material during production, or abnormal spoilage, will dramatically increase direct materials used.

Not every ounce of direct material ends up in your final product. Always expect some spoilage. Abnormal spoilage can happen because of faulty raw materials, untrained workers, or with a coffee shop, a tear in a bag of coffee beans.

3. Run a materials quantity variance

If you’re hankering for more direct materials analysis, run a materials quantity variance.

The materials quantity variance compares the actual and expected use of direct materials within a given period. The analysis highlights production inefficiencies, such as abnormal spoilage.

Frequently Asked Questions for Direct Materials

What’s the difference between raw materials and direct materials?

Direct materials are a type of raw material. Direct materials are the raw materials that end up in your final product, but not all raw materials have the same fate.

The protective equipment a factory worker wears and the cleaning supplies used on machinery are still considered raw materials essential to production. However, customers usually don’t get to take home a factory worker’s glove with purchase.

Raw materials that don’t wind up in a final product are called indirect materials, explained next.

What are indirect materials?

Indirect materials refer to materials consumed during the manufacturing process. Glue, nails, and gas are considered indirect materials.

Indirect materials are considered the catch-all, manufactured overhead account, which includes a host of fixed and variable production costs.

What are examples of direct materials?

Direct materials are the basis of any finished product. Direct materials include:

• Cotton in a t-shirt

• Steel in a building’s structure

• Screws in a piece of furniture

• Zippers on a jacket

Direct your attention to direct materials

Knowing the exact amount of direct material used in production will make other aspects of your job easier, such as figuring out when to order more raw material or identifying abnormal manufacturing runs.

The post A Small Business Guide to Direct Materials appeared first on The blueprint and is written by Ryan Lasker

Original source: The blueprint

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