What is Raw Materials Inventory?

A benchmark of a good inventory management process is the systematic acquiring and manufacturing of raw materials into the business’s finished goods. This raw materials inventory is a large part of the manufacturing process if your company produces its own products.

This raw materials inventory guide can help small businesses navigate the process of acquiring and using raw materials in their manufacturing process.

Raw materials inventory refers to a business’s stock of materials that have yet to be used in the manufacturing process to create a finished product. During this production process, raw materials are used to create work in process inventory or work in progress inventory, which turns into finished goods to be sold by the business.

Inventory tracking is an important part of supply chain management when it comes to the raw materials used to create work-in-progress inventory, and later the finished products. Stock levels must be monitored and costs and labour must be accounted for.

Therefore, keeping track of the types of inventory and the materials used to create those inventories is an essential part of proper inventory management. That’s why many businesses turn to inventory management software to help with this process.

Types of Raw Materials

Depending on the type of finished merchandise a business sells, it will possess multiple kinds of raw materials inventory. These are the two types of raw materials inventory:

  • Direct materials: All materials used in the construction of the finished product are known as direct materials. If a company makes office furniture, their direct materials would include plastic, wood, metal, and textiles, which will be turned into chairs, couches, tables, and the like.
  • Indirect materials: All materials consumed during the manufacturing of the finished goods are known as indirect materials. Indirect materials are used up in the manufacturing process but are not part of the finished product. Such indirect materials include disposable tools and equipment, cleaning supplies, oil, rags and so on.

Examples of raw materials

Suppose Dexter runs a small picture framing business. To construct frames for clients, Dexter will need to take stock from his raw materials inventory. When producing a frame, he will use direct materials such as wood and glass and indirect materials such as wood glue, rags, and varnish.

Why Do Businesses Have Raw Material Inventory?

Companies that sell goods can purchase finished products or acquire raw materials and make the finished products themselves. The reason why businesses decide to carry raw materials inventory is based on a few different factors:

  1. It is cheaper to buy the materials and produce the product than it is to buy the finished product outright
  2. It makes custom production easier
  3. To reduce transportation costs and transit times for high demand materials by having them on hand
  4. To prepare for production demand variations
  5. For seasonal demand
  6. To create a more efficient and financially viable procurement process

To implement the manufacturing process within the business, you will need to have your inventory management under control. Part of good inventory management is finding reliable and efficient suppliers.

Where Do You Get Raw Materials From?

When businesses use raw materials, they must source them from somewhere. Depending on whether the company acquires raw materials locally or overseas, the transportation time and costs will directly affect the manufacturing process and the business’s bottom line. Either way, companies can purchase raw materials from a vendor or supplier.

When sourcing raw materials, you will want to find and work with suppliers that are reliable and transparent. When securing a supplier, businesses can look for manufacturers, distributors, individual suppliers, or import foreign goods.

But before you can purchase your raw materials, you must first determine how much of what is required to make your finished products. Companies used a method called materials planning to help them do this. Businesses can calculate how much they need for current and future production, forecasting seasonality, market changes, and other factors using historical data of previously consumed materials.

How Do You Calculate Raw Materials Inventory?

To calculate raw materials inventory, you will have to have information available on a few specific things:

  • Beginning raw materials inventory: The number of raw materials in your stock at the start of an accounting period
  • Raw materials purchased: Concerning the number of raw materials purchased during the accounting period in question
  • Cost of goods sold (COGS): the cost of purchasing or manufacturing the products that the business sells during a specific period, including all labour, materials, and overhead costs associated with the assembly process

With these things in mind, you can calculate the total raw materials your business is holding by using the following formula:

Beginning inventory + Purchases added – Ending inventory = Total Raw Materials

Businesses will predominantly use the raw materials inventory formula for finding the ending inventory amount for an accounting period. Remember, the ending raw materials inventory is used as the beginning raw materials inventory for the following period. This formula is as follows:

(Raw Materials Inventory Purchased + Beginning Raw Materials Inventory) – COGS = Ending Raw Materials Inventory

How Do You Calculate Raw Materials Inventory Turnover?

The raw materials inventory turnover is the rate at which raw materials are used and replaced. This figure is represented as a ratio. To determine the turnover rate of your raw materials inventory, you will first need the average cost of your raw materials inventory using the beginning and ending inventory amounts:

Beginning Raw Materials Inventory + Ending Raw Materials Inventory / 2 = Average Cost of Raw Materials Inventory

Once you have the average cost, you can complete the raw materials inventory turnover ratio formula:

COGS / Average Cost of Raw Materials Inventory = Turnover Ratio

Companies will want to aim for a turnover ratio between 4 and 6, as this is considered the ideal balance of selling their products and replacing the raw materials.

This ratio helps businesses identify whether their inventory forecasting and materials planning is working well. A high rate of inventory turnover means the business is quicker to offload products and reorder materials. A low turnover rate is indicative of a disconnect between acquiring the raw materials and using them in the supply chain.

How Do You Track Raw Materials?

When a business acquires raw materials, they must be accounted for in the accounting ledger. Raw materials are highly impactful to a business’s financial performance, as they are recorded as current assets on the balance sheet. Sometimes, companies combine their raw materials into a single line item for all inventory, including work-in-process and finished goods inventory.

When raw materials are first purchased, businesses should use double-entry accounting to debit the raw materials inventory account and credit accounts payable for the same amount. Once the raw materials are consumed in the manufacturing process, another double-entry must take place.

Direct materials used will have you debit the work-in-process inventory account and credit the raw materials inventory asset account. On the other hand, indirect materials used will see you debiting the factory overhead account while crediting the raw materials inventory asset account. Such entries are an important part of inventory accounting.

QuickBooks Online can help businesses manage their raw materials and inventory on and off the balance sheet, with accounting and inventory management software capabilities. Improve your inventory management today when you start your free trial of QuickBooks Online.

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