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Key Takeaways
- Raw materials are the fundamental inputs in the production of goods, serving as crucial factors in the global economy and influencing international trade and national GDP growth.
- They are categorized into direct and indirect raw materials, where direct raw materials are visibly used in the finished product (such as wood in furniture), whereas indirect raw materials support the production process but do not directly appear in the finished product.
- Manufacturing companies handle raw materials inventory with detailed accounting methods, considering costs like shipping and storage to ensure accurate budgeting and financial reporting.
- Understanding the difference between inventory classifications for raw materials, work-in-process, and finished goods is essential for businesses in managing production and financial accounting.
- Strategic sourcing of raw materials, either through reliable third parties or direct production, is a vital business decision that impacts financial efficiency and operational sustainability.
Investopedia / Nez Riaz
What Are Raw Materials?
Raw materials are essential materials or substances used as inputs for the primary production or manufacturing of goods. Two categories of raw materials are direct and indirect, which must be accounted for differently. Businesses must strategically source and budget for raw materials, as well as for their storage or disposal.
Insight Into Raw Materials and Their Uses
Raw materials are used in a multitude of products and can take many different forms. Raw materials are the input goods or inventory that a company needs to manufacture its products. For example, the steel used to manufacture vehicles would be a raw material for an automobile manufacturer. For manufacturing companies, raw materials inventory requires detailed budgeting and a special framework for accounting on the balance sheet and income statement.
Raw materials are often related to natural resources. For this reason, manufacturing companies may be at the mercy of Mother Nature regarding the availability of raw materials. In the same light, manufacturing companies may not want to directly invest in extracting the raw materials. For example, consider how a company that relies on oil or plastics often does not own the drilling rig that extracts the raw materials from the group.
Important
Examples of raw materials include steel, oil, corn, grain, gasoline, lumber, forest resources, plastic, natural gas, coal, and minerals.
How to Account for Raw Materials in Manufacturing
Manufacturing companies take special steps to account for raw materials inventory. This includes three distinct inventory classifications on their balance sheet compared to just one for non-manufacturers. The current assets portion of the balance sheet represents the assets that are likely to be used up in less than one year and includes:
- Raw materials inventory
- Work-in-process
- Finished goods
All inventory, including raw materials inventory, should be valued at its comprehensive cost. This means its value includes shipping, storage, and preparation. The typical journal entries in an accrual accounting system for the initial purchases of raw materials inventory include a credit to cash and a debit to inventory. Debiting inventory increases current assets, and crediting cash will reduce cash assets by the inventory amount.
When a company uses raw materials inventory in production, it transfers them from the raw materials inventory to the work-in-process inventory. When a company completes its work-in-process items, it adds the finished items to the finished goods inventory, making them ready for sale.
Comparing Direct and Indirect Raw Materials
Raw materials can be divided into direct and indirect categories. Whether a raw material is direct or indirect influences where it appears on the balance sheet and how it is expensed on the income statement.
Direct Raw Materials
Direct raw materials are used directly in making a product, like wood for a chair. Direct raw materials are placed in current assets and are expensed on the income statement within cost of goods sold.
Manufacturing companies take extra steps to create detailed expense reports on the cost of goods sold. Direct raw materials are typically considered variable costs since the amount used depends on the quantities being produced.
Direct Raw Materials Budget
A manufacturer calculates the amount of direct raw materials it needs for specific periods to ensure there are no shortages. Tracking direct raw materials closely can reduce stock, lower costs, and cut the risk of obsolescence.
Raw materials can degrade or become unusable, leading the company to declare them obsolete. If this occurs, the company expenses the inventory as a debit to write-offs and credits the obsolete inventory to decrease assets.
Indirect Raw Materials
Indirect raw materials are not part of the final product but are instead used comprehensively in the production process. Indirect raw materials are recorded as long-term assets, possibly under categories like selling, general, and administrative (SG&A) or property, plant, and equipment (PP&E).
Long-term assets usually follow a depreciation schedule that allows them to be expensed over time and matched with the revenue they help produce. For indirect raw materials, depreciation timing will usually be shorter than other long-term assets, like a building expensed over several years.
Fast Fact
Companies may make an entirely independent budget specific for raw materials when preparing its annual manufacturing or production budget.
Different Classifications of Raw Materials
Raw materials can be classified in several ways, but one common classification is the nature of how the good is extracted. These types include:
- Mined raw materials extracted from the earth, such as ores, stones, metals, minerals, lime, sand, soil, oil, and coal.
- Plant-based raw materials come from trees or plants, including fruits, nuts, flowers, vegetables, resins, wood, cotton, and latex.
- Animal-based raw materials are extracted from animals such as milk, meat, fur, leather, and wool.
Raw materials are often segregated into these three categories, as each type often entails very different investments to procure the raw materials. For example, the operations of a farm are substantially different from those of an oil drilling rig; companies that require both raw materials must be mindful of how to most efficiently source the materials.
Practical Examples of Raw Material Use in Manufacturing
Consider a company that manufactures tables and chairs. Below are the materials used in production:
- Direct raw materials: timber, wood, cushions, padding for the chairs, and cloth fabric to cover the chairs
- Indirect raw materials: fittings, nails, wood glue, equipment for workers
Since the wood, padding, and fabric can be directly tied to the production of the tables and chairs, they are considered direct raw materials. When calculating the cost on a per-unit basis, the direct raw materials could be traced to each unit.
The glue, nails, and worker equipment would likely be considered indirect materials since the quantities used would not be significant, nor would they be directly tied to each unit produced. These types of costs would likely be allocated to a product via manufacturing overhead.
What Are Raw Materials in Food?
Raw materials in food can be standalone items like meats, milk, fruits, and vegetables. They can also refer to the ingredients that go into a food item or recipe. For instance, milk is a raw material used in the production of cheese and yogurt.
Is Water a Raw Material?
Yes, water can be thought of as a raw material that is used in a wide range of products and production processes, from beverages to agriculture to industrial uses.
What Is the Difference Between Inventory and Raw Materials?
In many cases, raw materials are a type of inventory. It represents goods on a balance sheet that have not yet been converted to work-in-progress or a finished product. Companies often buy, acquire, or extract raw materials for use, then report raw materials as an asset. Then, as the company uses raw materials in the production of finished goods, it converts the raw materials into products it can sell to consumers.
How Do Companies Get Raw Materials?
Companies are often very strategic in how they obtain raw materials. For many, it makes most financial sense to work closely with a reliable third-party that collects and distributes the raw materials. In other cases, it may be more efficient for companies to establish production facilities that directly collect the raw materials. The former path incurs ongoing operating expenses, while the latter path results in arguably less operating costs but greater upfront capital investment.
The Bottom Line
Raw materials are the inputs used in the production process to create finished products that are ready to sell to consumers. The types of raw materials include mined, plant-based, and animal-based materials, each of which affects procurement and business operations.
Direct raw materials become part of a final product and are accounted for as current assets included in the cost of goods sold. Indirect raw materials are used in the process of creating the product, but are not part of it, and are expensed using depreciation. These different accounting methods have significant financial implications for manufacturers, necessitating strategic sourcing and effective inventory management.
