Raw materials inventory definition
/What is Raw Materials Inventory?
Raw materials inventory is the total cost of all component parts currently in stock that have not yet been used in work-in-process or finished goods production. There are two subcategories of raw materials, which are:
Direct materials. These are materials incorporated into the final product. For example, this is the wood used to manufacture a cabinet.
Indirect materials. These are materials not incorporated into the final product, but which are consumed during the production process. For example, this is the lubricant, oils, rags, light bulbs, and so forth consumed in a typical manufacturing facility.
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Presentation of Raw Materials Inventory
The cost of raw materials on hand as of the balance sheet date appears in the balance sheet as a current asset. Raw materials may be aggregated into a single inventory line item in the balance sheet that also includes the cost of work-in-process and finished goods inventory. In the following exhibit, inventory is broken out on the balance sheet, so that you can see each component of it.
Accounting for Raw Materials Inventory
Raw materials of all types are initially recorded into an inventory asset account with a debit to the raw materials inventory account and a credit to the accounts payable account. When raw materials are consumed, the accounting treatment varies, depending on their status as direct or indirect materials. The accounting is:
Direct materials. Debit the work-in-process inventory account and credit the raw materials inventory asset account. Or, if the production process is brief, bypass the work-in-process account and debit the finished goods inventory account instead.
Indirect materials. Debit the factory overhead account and credit the raw materials inventory asset account. At the end of the month, the ending balance in the overhead account is allocated to the cost of goods sold and ending inventory.
Raw materials may sometimes be declared obsolete, possibly because they are no longer used in company products, or because they have degraded while in storage, and so can no longer be used. If so, they are typically charged directly to the cost of goods sold, with an offsetting credit to the raw materials inventory account.
Best Practices for Raw Material Inventory
There are several best practices related to raw material that reduce your investment in this inventory area, while also maintaining tight control over the related costs. These best practices are noted below.
Implement Just-in-Time (JIT) Purchasing
Just-in-Time (JIT) purchasing is a strategy where raw materials are ordered and received only as they are needed for production. This reduces the need to maintain large quantities of inventory, which lowers storage, insurance, and handling costs. It also minimizes the risk of materials becoming obsolete or spoiled due to prolonged storage. By freeing up capital that would otherwise be tied up in inventory, businesses improve their cash flow. However, JIT requires reliable suppliers, accurate demand forecasting, and strong coordination with production scheduling. Any delays in delivery can halt production, so contingency plans and solid supplier relationships are critical.
Maintain Accurate Inventory Records
Maintaining accurate inventory records is essential for ensuring that raw materials are available when needed, without overstocking or stockouts. Inventory records should reflect real-time data on quantities, locations, and usage. This helps in making informed purchasing decisions and supports smooth production planning. Modern inventory management systems using barcodes or RFID can automate updates and reduce human error. Accurate records are also vital for financial reporting and audits, as discrepancies can lead to misstated financial results. Regular reconciliation between physical counts and system records ensures ongoing accuracy and accountability.
Classify Inventory Using ABC Analysis
ABC analysis categorizes raw materials based on their consumption value: ‘A’ items are high-value with tight controls, ‘B’ are mid-range, and ‘C’ are low-cost and often used in bulk. This classification allows businesses to focus their inventory management efforts where they matter most. By prioritizing resources on ‘A’ items, companies can improve accuracy and avoid costly shortages or overages. It also allows for differentiated policies—for example, frequent reviews for ‘A’ items versus periodic checks for ‘C’ items. ABC analysis enhances both efficiency and cost-effectiveness by aligning control efforts with material importance. Regular reclassification ensures the system stays relevant as consumption patterns shift.
Conduct Regular Cycle Counts
Cycle counting is the practice of regularly counting a portion of the inventory on a rotating schedule, rather than doing one large annual physical count. This method improves inventory accuracy while minimizing disruptions to daily operations. It allows errors or discrepancies to be identified and corrected quickly, reducing the risk of stockouts or overstocking. Prioritizing high-value or fast-moving items for more frequent counting enhances financial accuracy and operational efficiency. Implementing cycle counts also builds a culture of accountability among warehouse staff. Over time, cycle counting can reduce the need for large year-end adjustments and improves overall inventory visibility.
Track and Reduce Material Waste
Tracking raw material waste helps companies understand where losses are occurring, whether through spoilage, damage, or inefficiency in handling and production. Identifying root causes of waste enables the implementation of targeted solutions, such as improved storage conditions or staff training. Reducing waste not only cuts direct material costs but also lowers disposal fees and environmental impact. Monitoring waste also supports sustainability initiatives, which can enhance a company’s brand reputation and compliance with environmental regulations. A consistent waste reduction strategy leads to more efficient use of resources and better profit margins.