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Raw Materials: What It Is, Direct vs. Indirect

What Are Raw Materials?

Raw materials are the fundamental elements used in the manufacturing of goods or the provision of services. These materials are typically in their natural, unprocessed state and serve as the building blocks for the production process. They can be sourced from various sectors, including agriculture, mining, forestry, and fishing.

Difference Between Raw Materials and Inventory

Often, raw materials serve as a specific inventory category, signifying items listed on a balance sheet that haven’t yet transformed into work-in-progress or finished goods. Companies frequently procure, obtain, or extract raw materials for subsequent use, categorising them as assets. As these raw materials are employed in producing finished goods, the company transforms them into sellable products for consumers.

Raw Materials in Food

Raw materials in food encompass independent elements such as meats, milk, fruits, and vegetables. Additionally, they denote the components constituting a food item or recipe. For instance, milk serves as a raw material in the manufacturing process of cheese and yoghurt.

How Businesses Get Raw Materials

Businesses usually adopt strategic approaches when acquiring raw materials. For many, partnering with a dependable third-party responsible for gathering and distributing raw materials aligns with their financial objectives. Some may find it more effective to establish production facilities for direct raw material collection. The former approach involves continual operating expenses, whereas the latter entails potentially lower ongoing operating costs but demands higher initial capital investment.

Accounting for Raw Materials

Manufacturing enterprises follow specific procedures to manage their raw materials inventory, employing three distinct inventory classifications on their balance sheets, as opposed to the single classification used by non-manufacturing entities.

The current assets section of the balance sheet encompasses assets likely to be depleted within a year, including:

  • Raw materials inventory
  • Work-in-process
  • Finished goods

All inventory, including raw materials, must be assessed at its comprehensive cost, incorporating expenses such as shipping, storage, and preparation. In an accrual accounting system, the standard journal entries for initial raw materials inventory purchases involve crediting cash and debiting inventory. Debiting inventory augments current assets, while crediting cash diminishes cash assets by the inventory’s amount.

As raw materials are utilised in production, they transition from raw materials inventory to work-in-process inventory. Upon completion of work-in-process items, companies incorporate the finished items into finished goods inventory, rendering them available for sale.

Direct vs. Indirect Raw Materials

Raw materials can be categorised into two groups: direct and indirect. The classification of a raw material as direct or indirect impacts its placement on the balance sheet and its treatment in expense reporting on the income statement.

Direct Raw Materials

Direct raw materials refer to the materials used directly in manufacturing a final product, like using wood for crafting a chair. These materials are categorised as current assets and are expensed within the cost of goods sold on the income statement.

Manufacturing firms need to undertake additional measures compared to non-manufacturing entities for detailed expense reporting related to the cost of goods sold. Usually, direct raw materials are regarded as variable costs due to their dependency on the quantities produced.

A manufacturer determines the required quantity of direct raw materials for specific timeframes to prevent shortages. By meticulously monitoring the acquisition and utilisation of these materials, a business can minimise excessive inventory, potentially cutting down on ordering expenses, and mitigating the risk of material obsolescence.

Raw materials might deteriorate during storage or become unsuitable for use in a product due to various factors. In such instances, the company deems them obsolete. When this happens, the company records the inventory as an expense by debiting write-offs and reduces assets by crediting the obsolete inventory.

Indirect Raw Materials

Indirect raw materials aren’t incorporated into the final product but are extensively used throughout the production process. These materials are categorised as long-term assets and can be allocated to various categories within long-term assets, such as selling, general, and administrative (SG&A), or property, plant, and equipment (PP&E).

Long-term assets usually adhere to a depreciation schedule, allowing their expenses to be spread over time and aligned with the revenue they contribute to generate. In the case of indirect raw materials, the depreciation timeline usually tends to be shorter compared to other long-term assets, like a building whose expenses are spread over several years.

Types of Raw Materials

Raw materials can undergo various classifications, with one common categorization based on how these goods are obtained.

  • Plant-based raw materials obtained from trees or plants, encompassing fruits, nuts, flowers, vegetables, resins, wood, cotton, and latex.
  • Animal-based raw materials harvested from animals, such as milk, meat, furs, leather, and wool.
  • Mined raw materials sourced from the earth, like ores, stones, metals, minerals, lime, sand, soil, oil, and coal.

These classifications help in segregating raw materials into distinct groups due to the considerable differences in the procurement investments associated with each type. For instance, the operations involved in running a farm differ from those of an oil drilling rig. Companies requiring both types of raw materials must strategically consider how to optimally source these resources.

Example of Raw Materials

The role of raw materials is multifaceted in resource-laden countries such as Australia. The mining sector contributes significantly to the country’s economy, providing a plethora of minerals and metals used both domestically and in global markets. Also, Australia’s agricultural sector contributes diverse raw materials to various industries, from food and beverages to textiles.

A wood furniture store may even take pride in sourcing their timber from a sustainable forest.

Raw materials serve as essential components in manufacturing processes to create finished goods available for consumers. They hold significant importance within the global economy and international trade. Natural resources suitable for use as raw materials can bolster a country’s exports and contribute to the expansion of its GDP. Businesses and investors have the opportunity to participate in raw material trading markets via commodities markets.

DISCLAIMER: This article is for informational purposes only.

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