Raw materials are the physical goods or substances used as inputs in the production of finished products. They can be natural resources (iron ore, crude oil, timber), agricultural products (corn, milk), or basic processed materials (steel, plastic pellets). For manufacturers they are a form of inventory that must be purchased, stored, and consumed in production.
Key takeaways
– Raw materials are inputs to production and usually appear on the balance sheet as part of inventory (current assets) until used.
– They can be classified as direct (traceable to a finished product) or indirect (used in production but not part of the finished good).
– Valuation of raw materials includes the purchase price plus costs necessary to bring the material to usable condition (shipping, handling, customs).
– Effective raw-materials management covers procurement strategy, budgeting, inventory controls, quality, risk management (price and supply), and accounting treatments.
Source: Investopedia (Nez Riaz). See also accounting guidance on inventory (e.g., FASB ASC 330).
Understanding raw materials (types and examples)
By origin / nature
– Agricultural: grains, milk, fruits, vegetables
– Extractive / mining: oil, natural gas, coal, minerals
– Forestry: lumber, pulp
– Manufactured/processed inputs: steel, plastic resin, chemicals
By role in production
– Direct raw materials: physically incorporated into a finished product and traceable per unit (e.g., wood for a chair, steel for a car body, milk for cheese).
– Indirect raw materials: used in production but not physically part of the product or not easily traceable to specific units (e.g., lubricants, glue, cleaning solvents, small fasteners). These are typically treated as manufacturing overhead.
Common examples
– Automobile maker: steel, rubber, wiring harnesses
– Furniture: wood (direct), upholstery fabric (direct), glue/nails (indirect)
– Food processor: milk and sugar (direct), water (direct or utility), sanitizers (indirect)
Is water a raw material?
Yes — water can be a raw material when it is an input to a product (beverages, food processing, chemical reactions). It can also be a utility or process input (cooling, cleaning). How it is treated (raw material vs. overhead/utility) depends on its use and materiality for costing.
Raw materials vs. inventory
– Inventory is the umbrella category on the balance sheet that includes raw materials, work-in-process (WIP), and finished goods.
– Raw materials are the unconsumed inputs portion of inventory. When raw materials are issued into production, they move to WIP; when production finishes they move to finished goods.
Accounting basics (valuation, journal entries, classifications)
Valuation
– Raw materials inventory is recorded at cost, which generally includes purchase price plus directly attributable costs (freight-in, handling, import duties) necessary to bring the material to usable condition.
– Follow applicable accounting rules (e.g., FASB ASC 330 for U.S. GAAP) for inventory measurement and costing methods (FIFO, LIFO if permitted, weighted average).
Common journal entries (accrual accounting)
1) Purchase of raw materials on cash or credit:
• Debit Raw Materials Inventory
• Credit Cash or Accounts Payable
2) Issuance of raw materials into production (to WIP):
• Debit Work-in-Process Inventory
• Credit Raw Materials Inventory
(If indirect materials are consumed, debit Manufacturing Overhead and credit Raw Materials Inventory.)
3) Completion of production (move WIP to finished goods):
• Debit Finished Goods Inventory
• Credit Work-in-Process Inventory
4) Sale of finished goods (recognize cost of goods sold):
• Debit Cost of Goods Sold
• Credit Finished Goods Inventory
5) Obsolescence/write-off:
• Debit Loss on Inventory Write-off (or an expense account)
• Credit Raw Materials Inventory
Direct vs. indirect: why it matters
– Direct materials are charged to production and included in cost of goods sold when the related goods are sold.
– Indirect materials are generally expensed as part of manufacturing overhead and allocated across units produced.
Note: Some sources sometimes describe certain production inputs differently; in conventional cost accounting, indirect materials are NOT capitalized as long-term assets—most are current inventory until used and then expensed as overhead.
Raw materials budget — step-by-step
A raw materials budget helps ensure adequate supply while controlling inventory costs. A basic formula:
Raw materials to purchase = (Planned production units × Material per unit) + Desired ending raw materials inventory − Beginning raw materials inventory
Practical example
– Planned production: 10,000 chairs
– Material per chair (wood): 5 board-feet
– Desired ending RM inventory: 10,000 board-feet
– Beginning RM inventory: 6,000 board-feet
Calculate:
Required material for production = 10,000 × 5 = 50,000 board-feet
Purchases needed = 50,000 + 10,000 − 6,000 = 54,000 board-feet
Practical steps and best practices for managing raw materials
1) Forecast demand and calculate material requirements
• Use production plans to estimate material needs with the raw-materials budget formula above.
2) Establish inventory policies
• Set reorder points, safety stock levels, and economic order quantities (EOQ) where applicable.
• Decide on JIT (just-in-time) vs. safety-stock strategies based on supply risk and carrying cost.
3) Supplier strategy
• Diversify suppliers to reduce single-source risk.
• Negotiate contracts for price stability (fixed-price or indexed contracts).
• Use long-term agreements, consignment inventory, or vendor-managed inventory (VMI) where beneficial.
4) Price risk management
• For commodity inputs (oil, metals, agricultural goods), consider hedging tools such as futures/options or proxy hedges.
5) Quality control and inspection
• Implement incoming inspection and specifications testing to avoid production delays and scrap.
6) Storage and handling
• Ensure suitable storage conditions (temperature, humidity) to prevent spoilage or degradation.
• Track lot numbers and expiry dates for perishable inputs.
7) Inventory recording and costing
• Use an ERP or inventory system that tracks quantities, lot/serial numbers, and valuation.
• Reconcile physical counts to book balances regularly (cycle counts/annual counts).
8) Obsolescence management
• Monitor slow-moving or obsolete materials and write down or dispose as needed; document reasons and adjustments.
9) Sustainability and traceability
• For regulatory and brand reasons, track origin (conflict minerals, sustainable timber), use supplier audits, and maintain chain-of-custody records.
10) Continuous improvement and KPIs
• Track inventory turnover, days of inventory on hand, stockout frequency, fill rates, and carrying cost as % of inventory value.
Common metrics (KPIs)
– Inventory turnover = Cost of Goods Sold / Average Inventory
– Days Inventory Outstanding = 365 / Inventory Turnover
– Carrying cost of inventory (as % of inventory value): insurance, storage, capital, obsolescence
– Stockout rate and service level
Sourcing strategies: make vs. buy (vertical integration)
– Buy from market / specialist suppliers: lower capital expenditure, flexibility, but subject to supplier risk and price volatility.
– Make (vertical integration): greater control over supply and quality, potential cost savings long-term, but requires capital investment and operating complexity.
Decision factors: strategic importance of material, cost, quality, supply risks, and capital availability.
Risk management
– Supply risk: single-source disruption, geopolitical risks, natural disasters (e.g., weather affecting crops or mines).
– Price risk: commodity price volatility—consider hedging or long-term contracts.
– Quality/regulatory risk: nonconforming or recalled inputs.
– Operational risk: production delays from shortages—mitigate with safety stock, multiple suppliers, or increased visibility.
Regulatory and sustainability considerations
– Environmental and labor regulations affect sourcing (e.g., timber certification, conflict minerals).
– Increasing customer and investor demand for sustainable/ethical sourcing requires traceability and supplier audits.
Fast facts and practical notes
– Inclusion of freight-in, import duties, and handling costs in raw-material cost is common accounting practice.
– Raw materials are usually current assets until consumed; WIP and finished goods are subsequent inventory classifications.
– Perishability and obsolescence mean food and electronics manufacturers often hold less raw-material inventory relative to production needs.
Example: furniture manufacturer (practical allocation)
– Direct materials: wood, fabric, foam — traceable and allocated per unit.
– Indirect materials: glue, nails, sandpaper → charged to manufacturing overhead and allocated to products via overhead rates.
How companies get raw materials (procurement options)
– Spot market purchases
– Long-term supply contracts
– Futures and derivatives to hedge price
– Vertical integration (owning farms, mines, mills)
– Strategic alliances, consortia, or pooled purchasing
– Recycling and reclaiming (closed-loop supply)
The bottom line
Raw materials are fundamental production inputs that require careful planning, procurement, storage, accounting, and risk management. Good raw-materials management reduces production interruptions, controls costs, and improves profitability while meeting quality and regulatory requirements.
Primary source used
– Investopedia — “Raw Materials” (Nez Riaz).
Accounting reference
– U.S. GAAP guidance on inventory (see FASB ASC 330) for further technical accounting details.