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Material Cost vs. Price Plays Important Role in Sensitive Market

Direct material, direct labor and manufacturing overhead are the three categories into which expenses have been segregated to arrive at the cost of a manufactured product for over a century. Direct material represents the price paid to vendors for materials, components and purchased manufacturing services; direct labor represents the wages and benefits paid to those individuals who touch the product during a process that enhances its value; and overhead represents the myriad of manufacturing costs that cannot be attributed to a specific product, but are necessary to support the manufacturing process.

The practice of segregating costs in this manner was devised over 200 years ago by the 19th century British Economist David Ricardo, who created it as a model of the agricultural industry in England. Ricardo’s model was developed to account for corn—not manufacturing. It was not adopted by manufacturers because it was believed to be accurate, but rather because it was a methodology that already existed and was deemed to be the most practical model for implementation in an era when all data collection was done manually, and the technology to support computations consisted of abacuses, mechanical adding machines and comptometers.

As information technology began its spectacular advance during the latter part of the 20th century, accountants at manufacturing firms were quick to capitalize on the increased data manipulation and computational power to perform the calculations behind their corn-growing model more quickly and efficiently. However, despite the well publicized concerns that were raised about the inappropriateness of Ricardo’s cost model in a modern manufacturing environment, few accountants paid any attention to the fundamental structure of the cost model itself. They became super-efficient number crunchers, developing critical decision support information that was both inaccurate and misleading.

The Cost of Raw Materials, Components and Manufacturing Services
One area in which the deficiencies of Ricardo’s model have led to inappropriate decisions and deprived companies of millions of dollars in profits is non-labor direct costs. These are the amounts paid to outside organizations for raw materials, components and manufacturing services—items commonly included by accountants under the heading of “direct materials.”

Under Ricardo’s model, the cost of direct materials equals the price paid for them. Over the years, this definition has been expanded by some manufacturers to encompass “landed costs,” the price paid for a purchased item plus any freight, insurance, duties, taxes or other costs needed to get the item to the buyer’s receiving dock. Although an improvement from the simple “price paid” measurement, landed costs still ignore many of the critical factors that determine the true “cost” of a direct item purchased by a manufacturer.

The basic role of a manufacturing firm is to purchase raw materials, components and manufacturing services and then use a variety of value-adding processes to turn them into a finished product. Exhibit 1 shows this basic flow of manufacturing. Manufacturing does not begin until the start of a company’s first value-adding process. Before manufacturing can begin, however, a considerable amount of work is required to make sure the required purchased items or services are available when they are needed at the place they are needed. Materials and components do not appear by magic; neither do qualified contractors magically appear when required. Treating the price paid for such purchases as their only cost fails to take into account the work performed to insure that they are where they need to be when they need to be there. To fully understand “the cost” of a purchased item, all these costs must be included as part of that item’s cost. Have a look at the manufacturing flow illustrated in Exhibit 1.

Exhibit 1: Basic Manufacturing Flow

Exhibit 1_image