Raw Materials: Definition, Accounting, and Direct vs. Indirect

What Are Raw Materials?

Raw materials are materials or substances used in the primary production or manufacturing of goods. Raw materials are commodities that are bought and sold on commodities exchanges worldwide. Businesses buy and sell raw materials in the factor market because raw materials are factors of production.

Understanding Raw Materials

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 disposal of mother nature regarding the availability to secure 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.

Accounting for Raw Materials

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 include:

• 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.

Direct vs. Indirect Raw Materials

In some cases, raw materials may be divided into two categories: direct and indirect. Whether a raw material is direct or indirect will influence where it is reported on the balance sheet and how it is expensed on the income statement.

Direct Raw Materials

Direct raw materials are materials that companies directly use in the manufacturing of a finished product, such as 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 must also take added steps over non-manufacturing companies to create more detailed expense reporting on costs 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. By closely tracking the amount of direct raw materials bought and used, an entity can reduce unnecessary inventory stock, potentially lower ordering costs, and reduce the risk of material obsolescence.

Raw materials may degrade in storage or become unusable in a product for various reasons. In this case, the company declares 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 will be recorded as long-term assets. They can fall under several categories within long-term assets, including 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 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.

Types 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, furs, 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 an oil drilling rig; companies that require both raw materials must be mindful of how to most efficiently source the materials.

Example of Raw Materials

Consider a company manufactures tables and chairs. Below are the materials used in production:

• Direct raw materials: timber, wood, cushions, padding for the chairs, 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.

The Bottom Line

Raw materials are the inputs used in the production process to create finished products that are ready to sell to consumers. This makes raw materials a vital piece of the global economy and international trade. Having natural resources that can serve as raw materials can boost exports and help a country grow its GDP. Businesses and investors can engage in raw trading markets through commodities markets.