Direct material cost is the largest controllable expense in manufacturing—it’s usually at least one-third of total product costs and can reach as high as 70%. Tracking and optimizing direct material costs can help manufacturers improve margins, enhance forecasting accuracy, and build resilience against market volatility. In the best cases, strategic approaches to oversight of direct materials—in supplier negotiations, waste reduction, technology integration, process optimization, and more—can transform this major expense into a source of competitive advantage that boosts profitability and facilitates sustainable growth.

What Are Direct Material Costs?

Direct material costs comprise all expenditures tied to raw materials and components that become integral parts of a finished product. These costs are directly traceable to specific goods—think: steel in automobile frames, fabric in clothing, or flour in birthday cakes.

An illustrative example is the cost of materials needed to manufacture a smartphone: Microchips, display screens, and batteries would all be considered direct material costs. Unlike indirect costs—which support production but cannot be directly tied to specific products—direct materials become physically embedded in the final item. They’re a critical factor in calculating product costs and pricing.

Key Takeaways

  • Direct material costs typically represent 30% to 70% of total product costs and are crucial for accurate pricing, profitability analysis, and strategic planning.
  • Successful cost management requires a holistic approach that includes supplier negotiations, waste reduction, technology implementation, and precise tracking of all material-related expenses.
  • Forward-thinking manufacturers tend to view direct material cost management as an opportunity to pursue competitive advantage.
  • Modern cloud-based accounting software can help manufacturers more effectively manage direct material costs by integrating procurement, production, and financial systems to provide a unified view of operations.

Direct Material Costs Explained

Direct material costing involves tallying every expense required to source and prepare raw materials for production. This includes the base price of the materials—such as lumber for furniture or silicon for electronics—as well as ancillary costs, such as sales taxes, freight charges for transportation in, and storage fees incurred before manufacturing begins. Packaging, such as glass bottles for beverages or boxes for retail products, also qualify as direct materials if they’re essential to delivering the final item. Supplier discounts come into play here, as well.

Manufacturers that use the job costing accounting treatment, such as small-batch manufacturers and makers of custom furniture or clothing, trace direct material costs to specific jobs or batches. Companies that manufacture large volumes of identical or nearly identical products, such as steel, paint, beverages, and snacks, usually prefer process costing, in which direct materials costs are assigned to departments or production processes. For business leaders choosing between job and process costing, it’s important to know that job costing tends to provide a more precise value for direct materials than process costing but is not a practical method for tracking these costs in mass production situations.

Direct Material Costs vs. Indirect Material Costs

Another crucial characteristic is found in the comparison between direct and indirect material costs, both of which are needed to assess the true cost of manufacturing a product and, therefore, analyzing its profitability. Direct materials are unequivocally tied to specific products, such as the raw materials already discussed and the ancillary costs of preparing them for production. Their traceability allows precise assignment to specific units or batches.

Indirect materials, by contrast, support production but cannot be traced to any specific product. Machine lubricants, factory cleaning supplies, and safety gear for workers all fall into this category. Indirect material costs are included in manufacturing overhead, which is then distributed across all products in accordance with the company’s chosen cost allocation basis.

Direct and indirect materials costs are both included in finished products’ cost of goods manufactured and cost of goods sold (COGS) (when sold to customers). By rigorously analyzing these costs, manufacturers can unlock insights into production waste, pricing strategies, and supply chain efficiency.

Why Is Direct Material Costing Important?

Direct material costing is essential to manufacturing accounting because it directly affects profitability and operational efficiency—and, therefore, strategic decision-making. Furthermore, by accurately tracking direct material usage and its related costs, manufacturers can better forecast their material needs, thus diminishing material waste, curtailing excess inventory that ties up capital, smoothing out production schedules, and delivering the data needed to negotiate better terms with suppliers. Overall, effective management of direct material costs can save manufacturers as much as 10% to 20%.

What Is Generally Included in Direct Material Costs?

Direct material costs encompass several elements that manufacturers must track and manage. The most fundamental is raw material costs. These materials require transportation to production facilities, incurring freight charges. Before these materials enter production, they often need to be stored, which adds warehousing expenses to the total cost. These costs include:

  • Raw material costs: The base costs of materials used to manufacture the product. This cost can be reduced for supplier discounts or promotions.
  • Freight-in: The cost of transporting materials to the production facility.
  • Storage: Expenses for warehousing materials before use in production.
  • Components and parts: The cost of preassembled or semifinished items that are directly incorporated into the final product.
  • Packing materials: Costs of packaging materials necessary to finish, or deliver, the product.
  • Indirect taxes: These are any taxes paid by the manufacturer for the purchase of raw materials and components, such as value-added taxes and tariffs. They are “indirect” because, although the manufacturer pays them to a government, their cost is included in COGS and ultimately borne by the buyer.

How to Calculate Direct Material Costs

Accurate calculation of direct material costs accounts for all six of the elements described in the preceding section. It is essential for developing effective pricing, cost control measures, and profitability analyses. The formula is:

Direct material cost = [(Raw material cost + Indirect tax) – Discounts] + Freight-in + Storage + Packing

Some manufacturers might adjust this formula or add specific details to reflect the precise nature of their operations. But, by consistently calculating direct material costs across accounting periods, businesses can gain a detailed understanding of how the expenses associated with acquiring and preparing materials for manufacturing processes are trending. This allows for more accurate costing and decision-making.

Example Direct Material Costs Calculation

Let’s apply the formula to a hypothetical company’s production of 100 wooden tables. In this example, the costs are:

  • Raw materials: $4,500 (solid oak boards)
  • Indirect taxes: $450 (10% tax on raw materials)
  • Discounts: $225 (5% bulk purchase discount)
  • Freight/storage: $300 (transportation and warehousing costs)
  • Packing: $175 (packaging materials for finished tables)

Inserting these amounts into the formula, we get:

Direct material cost = [($4,500 + $450) – $225] + $300 + $175 = $5,200

Thus, the total direct material cost is $5,200, or $52 per table for 100 tables. As discussed earlier, however, this is not the full, true material cost. Indirect materials—screws, glue, finishing materials, and so on—are accounted for separately as part of manufacturing overhead and will be allocated to the tables in a subsequent accounting process.

Direct material costs are a foundational element of broader cost accounting practices, as they are a key component of COGS, which directly impacts gross profit and overall financial performance. Additionally, accurate tracking of these costs is essential for inventory valuation, budgeting, and pricing decisions.

Factors That Influence Direct Material Costs

Direct material costs are affected by a range of internal and external factors, including supply chain disruptions, market fluctuations, production efficiency, and supplier relationships. Each of these elements influences the overall cost, and a thorough understanding of them is vital for developing sound cost management strategies and enhancing forecasting accuracy. By identifying and analyzing these influences, businesses can develop strategies to manage risks, optimize costs, and improve financial outcomes:

  • Supply chain disruptions: Supply chain issues can lead to increased material costs, due to shortages or delays. These disruptions can result from natural disasters, geopolitical events, or global health crises, so wise managers develop contingency plans and diversify suppliers to mitigate risks.
  • Market rate for raw materials: Fluctuations in raw material prices directly affect material costs. Monitoring market trends and implementing hedging strategies can help businesses manage price volatility and stabilize costs.
  • Waste and spoilage: Inefficiencies in production processes can result in increased material waste and spoilage, driving up costs. Implementing lean manufacturing principles, effectively utilizing scrap, and introducing quality control measures can help. This is particularly important for operations managers charged with optimizing production efficiency.
  • Supplier changes: Switching suppliers or negotiating new contracts can significantly impact direct material costs. Though changing suppliers can offer cost savings, it’s essential not to overlook quality, reliability, and long-term partnership potential. Managers must carefully evaluate the total cost when making supplier decisions to ensure overall effectiveness.
  • Currency exchange rates: For businesses dealing with international suppliers, fluctuations in exchange rates add uncertainty to direct material costs. Currency hedging strategies or negotiating contracts in a stable currency can help mitigate this risk.
  • Regulatory changes: New regulations or changes in existing ones can affect material sourcing, usage, or disposal, potentially influencing direct material costs. Consequently, supply chain managers need to stay informed about relevant regulations and adapt procurement strategies accordingly.

How to Reduce Direct Material Costs

Direct material cost reduction strategies frequently blend supplier collaboration, process optimization, and technological innovation. Manufacturers implementing such strategies can usually cut direct material costs as they bolster supply chain resilience and sustainability. Steps to consider:

  1. Negotiate with suppliers for better prices: Securing volume discounts by committing to bulk purchases is a good way to lower per-unit costs. Strengthen relationships with reliable suppliers by way of long-term partnerships to gain favorable pricing and payment terms. Of course, companies should balance this with supplier diversification, which is often part of building resilient supply chains.
  2. Implement waste-reduction techniques: There are various ways to reduce waste, but lean manufacturing is a good place to start. For example, adopting Six Sigma practices to minimize scrap and rework can cut material waste, and recycling programs can repurpose scrap materials. Yield optimization, while primarily focused on boosting quality, has waste reduction as a direct byproduct.
  3. Consider alternatives in materials sourcing: Taking advantage of sustainable substitutes—replacing new materials with recycled or biodegradable alternatives, for instance—can do much to cut material costs. Reducing freight charges by using local suppliers is also helpful, as is consolidating material types across product lines to qualify for bulk pricing.
  4. Use technology to help optimize processes: Using advanced analytics tools to forecast material needs more accurately can be a powerful cost-cutting practice. So can augmented-reality tools that guide workers to minimize assembly errors and Internet of Things–enabled monitoring that tracks material usage in real time and identifies inefficiencies.

Strengthen Financial Controls With NetSuite Cloud Accounting Software

Managing direct material costs well demands that a business have strong financial controls and real-time visibility into its supply chain and procurement processes. NetSuite’s cloud accounting software is an artificial intelligence-powered financial management system that can deliver just such real-time visibility into a business’s financial performance from high-level consolidated views down to individual transactions. Thus, NetSuite makes it far easier for business leaders to track direct material costs across multiple suppliers and manufacturing processes.

Furthermore, NetSuite can automate core processes in inventory management, procurement, and supply chain operations, helping manufacturers cut down on manual bottlenecks that generate material cost overruns. Enabling that cross-functional visibility is NetSuite’s approach to integrating most business functions in one unified system, providing the means for businesses to better track material costs throughout the entire production process. With NetSuite, manufacturers can implement cost reduction strategies while maintaining the real-time financial visibility needed to make strategic decisions about material sourcing and usage.

Recognizing that direct material costs are their largest controllable expense, forward-thinking manufacturers are becoming intent on making material cost management a strategic imperative. They are looking to drive competitive advantage, for example, by negotiating volume-based supplier discounts while still maintaining supply chain diversity; by adopting lean manufacturing principles with measurable waste-reduction targets; by strategically substituting materials without compromising quality; and by deploying technology to create real-time visibility across procurement and production. Manufacturers that do this effectively stand the best chance of extracting the most value from every dollar they spend on direct materials.

Direct Material Costs FAQs

What are some examples of direct material costs?

Examples of direct material costs include raw materials, such as wood for furniture manufacturing, fabric for clothing production, and electronic components for device assembly. These materials can be traced directly to the products they become part of.

Is scrap a direct material cost?

Scrap can be considered a direct material cost when it’s an unavoidable part of the production process. However, unusually excessive scrap due to inefficiencies might be treated differently: as a period expense or a separate cost to analyze for process improvement opportunities. Proper classification of scrap cost is essential. When classified as a direct material cost, scrap (or the scrap rate) is included in the raw materials component of the direct material cost formula.

What are some examples of indirect material costs?

Indirect material costs include items that are used in production but are not easily traceable to a specific product. Examples include lubricants for machinery, cleaning supplies, and small tools. Though these costs are necessary for production, they are typically pooled together in manufacturing overhead and then allocated to products per the company’s chosen cost allocation basis.