Explanation of Direct Materials
All companies need a way to compute the cost of the product or service they sell. For a manufacturing company, the cost of the material needed to produce the product usually makes up a significant percentage of the cost of the product.
Direct materials are raw goods that can be traced directly to, or easily identified with, a specific product. These materials are easily separately identifiable as the product moves through the production process. For instance, bricks are direct materials for building companies and can be separately identified through all phases of constructing a building.
The flow of the direct materials through the production process starts with the receipt of raw materials. An accountant records direct materials as raw material inventory when the company first receives them. Inventory controls include assigning the materials a unique inventory number. The accountant records the quantity and purchase price of each delivery against each inventory number as part of the inventory control process.It is possible to control inventory items through an inventory management system which is any system used to track the increase or decrease of inventory. The entry in the general ledger for the receipt of the inventory is a debit to the raw material inventory account. Inventory is an asset. This receipt of raw material affects the inventory management system and general ledger. If the company buys inventory on an open account, then the credit entry will be to accounts payable. Suppose G&E Building Company purchases bricks on credit. The company makes a general ledger entry to record the receipt of the bricks.
G&E Building Company Journal Entry
|1/1/2019||Raw Material Inventory||$5,000|
|To record the purchase of bricks on credit.|
Raw Material Journal Entry
|1/15/2019||Work in Process Inventory||$5,000|
|Raw Material Inventory||$5,000|
|To record the move of bricks to Work in Process|
Finished Goods Journal Entry
|1/25/2019||Finished Goods Inventory||$5,000|
|Work in Process Inventory||$5,000|
|To record the move of bricks to Finished Goods|
Direct Materials Flow of Costs
To calculate the price of an item, accountants and managers use absorption costing, which is a type of costing that combines direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Absorption costing is a generic term used for a costing system that absorbs overhead costs. Both job order and process costing are types of absorption systems.
Absorption costing is often contrasted with variable costing, where all fluctuating expenses from manufacturing are considered as part of inventory expenses. A variable cost is an expense that changes with the level of production. Variable costing and absorption costing differ based on the classification of a manufacturing cost as either fixed or variable. Absorption includes both fixed and variable costs in determining the product cost that is recorded in inventory.
At first glance, it may seem that including all costs in inventory is the most logical approach. However, doing so produces some discrepancies in calculating unit costs.
To determine the cost of the product under absorption costing, first determine the variable cost. A variable cost will stay the same per each unit, but the total cost will vary based on the number of units produced. If the cost of each unit is determined to be $5, then that will be the cost per unit assigned to all units. A fixed cost is an expense related to operating a company for a specific period of time that remains unchanged despite any change in the company's activity level. For example, if fixed costs are $10,000, then the unit cost will be $1 if 10,000 units are produced. If production drops and only 5,000 units are produced, then the unit cost will be $2. If the variable cost per unit is $5, this means the total unit cost could be $6 or $7 in this example. The fixed costs will stay the same, but the unit cost will change depending on the number of units produced.
Because of the allocation of the fixed costs, the use of absorption costing can allow a company to improve its calculated profit position simply by overproducing. If the units in the example sell for $15, then the company makes a profit of $8 on units sold if they produce 5,000 units. However, if the company increases production to 10,000 units, then the profit on units sold increases to $9.Generally accepted accounting principles (GAAP) are rules and standards adopted by the Securities and Exchange Commission that companies must follow when they report financial information. While GAAP does not govern many of the decisions in cost accounting, it does govern the valuation of inventory. That is because companies report inventory on their balance sheets. A company can use either absorption or variable costing for internal purposes, but absorption costing is required for any external reporting. A company may use variable costing for internal analysis in order to evaluate the profitability at both the variable cost and the fully absorbed levels. In this way, the organization can evaluate profitability with and without consideration of production levels.
Allocation of Material Costs
The costs of materials to produce products can be either direct and indirect. Indirect materials are related to the cost of the product as part of the overhead allocation process. Both direct and indirect materials apply to the product cost in process costing and job order costing. Process costing means applying costs to an entire process instead of an individual product. Businesses often use it when they are producing huge numbers of similar products. Job order costing is a system that companies use when they want to know how much each product or service costs to create. Both process and job order costing are absorption costing systems.
Manufacturing firms that make custom products use job order costing to manage the cost information for their products. The flow of direct materials with this type of costing is fairly easy to trace. The specific raw material can be identified when received, when it is moved onto the job as a work in process, and when it is part of the finished product.
Businesses use process costing for products where materials are applied to a batch of items rather than an individual item. Companies need to use process costing when production of the same product happens continuously. The flow of materials moves in the same way as job order costing, but raw materials—in other words, the basic items that a business uses to make a product—cannot be tracked to specific products. Indirect materials are part of the overhead application process, or the process that assigns fixed costs to a product based on a predetermined rate or other system.
An example of raw material application in process costing is the costing for production of Hershey's Kisses. In this case, the business applies the direct material to a process or department. For example, in chocolate candy manufacturing, the final production department is tempering and molding. If the manufacturer wants to add almonds to the individual chocolates, it would do so in this department. The direct material cost of the almonds would be added to the cost of production of the product in this department. The company could instead choose to identify this as a process cost and accumulate the costs of almonds under the molding process. The selection of using a process or department in analyzing costs in process costs is up to the company.
Process differences exist in manufacturing depending on the type of products produced. However, the flow of material costs from raw material to work in process to being part of the final product is the same.