What Are Raw Materials?
Raw materials are crucial substances or commodities that play a foundational role in the primary production or manufacturing of goods. Globally, these materials are bought and sold in various commodities exchanges. Companies acquire raw materials in the factor market, where these resources function as essential factors of production.
Key Takeaways
- Raw materials serve as the input goods or inventory required by a company to manufacture its products.
- Typical examples of raw materials include steel, oil, corn, grain, gasoline, lumber, forest resources, plastic, natural gas, coal, and minerals.
- Direct raw materials are those directly used in the production process, such as wood in the making of furniture, whereas indirect raw materials support the production process but aren’t part of the final product.
- The value of direct raw materials inventory is recorded as a current asset on the balance sheet.
Unlocking the Mysteries of Raw Materials
Raw materials come in numerous forms and are indispensable to creating a multitude of products. For instance, steel is a prerequisite for manufacturing vehicles in an automotive factory. Manufacturing companies must meticulously budget and account for raw materials within their balance sheets and income statements.
Given their link to natural resources, manufacturing entities often depend on natural availability or external suppliers for raw material procurement. A company involved in producing plastic items typically does not own the facilities that extract the crude oil used in their production.
Examples of raw materials include steel, oil, corn, grain, gasoline, lumber, forest resources, plastic, natural gas, coal, and minerals.
How Companies Account for Raw Materials
Manufacturing companies categorize their inventory into three specific classifications on their balance sheets:
- Raw materials inventory
- Work-in-process
- Finished goods
All inventory is valued comprehensively, meaning the cost includes shipping, storage, and preparation. Standard journal entries in an accrual accounting system for the initial purchases of raw materials consist of a debit to inventory and a credit to cash, reflecting the cost basis of the inventory.
Once raw materials are utilized in production, they transition from raw materials inventory to work-in-process inventory. Upon completion, the items move to finished goods inventory, ready for sale.
Differentiating Between Direct and Indirect Raw Materials
Raw materials can be classified as direct or indirect, influencing their reporting and expense handling.
Direct Raw Materials
Direct raw materials are directly used in manufacturing a finished product, such as wood for furniture. These materials are considered current assets and are expensed in the income statement as part of cost of goods sold (COGS). They are treated as variable costs, directly tying their usage to production quantities.
Manufacturers carefully document raw material usage to prevent shortages, minimize excessive inventory, control ordering costs, and avoid material obsolescence. In cases where raw materials become unusable, they are expensed as obsolete inventory.
Indirect Raw Materials
Indirect raw materials are not part of the end product but are essential to the production process. These materials are considered long-term assets and may fall under categories such as selling, general, and administrative (SG&A) or property, plant, and equipment (PP&E). Indirect raw materials follow a depreciation schedule matching revenue generated by producing processes.
Types of Raw Materials
Raw materials may be classified based on their extraction processes:
- Mined Raw Materials: Extracted from the earth, such as ores, metals, minerals, oil, and coal.
- Plant-based Raw Materials: Sourced from trees or plants, including wood, cotton, latex, and various agricultural products.
- Animal-based Raw Materials: Obtained from animals, such as leather, wool, and meat.
Enhancing Your Understanding with Real-World Examples
Imagine a company specializing in manufacturing tables and chairs. The materials include:
- Direct raw materials: Timber, wood, padding, fabric.
- Indirect raw materials: Nails, glue, equipment for workers.
Direct materials are easily attributable to each produced unit, whereas indirect materials are allocated via manufacturing overhead.
Perspectives on Raw Materials in Food Production
In food production, raw materials can be ingredients like milk for cheese or standalone items such as fruits and vegetables.
The Crucial Role of Water as a Raw Material
Water is classed as a raw material essential for many processes, ranging from beverages to industrial applications.
Clarifying the Distinction Between Inventory and Raw Materials
Raw materials represent just one type of inventory consisting of unfinished goods not yet transformed into a finished product.
Strategic Approaches to Sourcing Raw Materials
Companies strategize to source raw materials either through reliable third-party entities or by establishing their production facilities, balancing operating costs and capital investment intricacies.
Conclusion: The Global Impact of Raw Materials
Understanding raw materials is essential to grasping economic and production processes worldwide. As the building blocks of product creation, raw materials significantly influence global trade and economic growth. Businesses and investors keenly monitor and trade in raw material markets to align with international economic trends.
Related Terms: Commodity, Factor Market, Balance Sheet, Income Statement, Work-in-Process.
