Understanding Raw Materials: Definition, Accounting, Types, and Uses

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Raw materials are the basic substances and inputs a business converts into finished goods. They include extracted resources such as ore, crude oil and timber, farm output such as corn and cotton, animal products such as milk and wool, and in many industries, processed goods bought from another firm. Steel is a raw material for a carmaker, and flour is a raw material for a bakery. In accounting, raw materials are a category of inventory: items purchased for production that have not yet entered the manufacturing process.

What raw materials are

A raw material is defined by its role, not by its form. Iron ore is a raw material for a steel mill, and the mill’s finished steel coil is a raw material for an appliance maker. Both are inputs that the buyer will transform.

Water also counts as a raw material when it goes into a product or process. It is the main ingredient in beverages and a process input in agriculture and many industrial operations. In food production, raw materials include meat, milk, fruit and vegetables. Milk, for example, is the raw material for cheese and yogurt.

Direct and indirect raw materials

The direct or indirect label decides how a material’s cost reaches the product and, later, the income statement.

Direct raw materials

Direct materials are physically part of the finished good, and their cost can be traced to each unit without much effort. Wood in a chair, fabric on a sofa and flour in bread are direct materials. When they enter production, their cost moves into work in process. It becomes part of cost of goods sold (COGS) when the finished units are sold.

Direct materials are a variable cost. Producing twice as many chairs requires roughly twice as much wood, so total direct material cost rises and falls with output.

Indirect raw materials

Indirect materials are consumed in production but are either not part of the product or too small to trace to individual units economically. Glue, nails, screws, lubricants, cleaning supplies and small consumables usually fall here. Their cost goes into manufacturing overhead and is then allocated to products using an overhead rate, for example a rate per machine hour or per direct labor hour. Through that allocation, indirect material cost also reaches inventory and eventually COGS.

Indirect materials are sometimes described as long-term assets that are depreciated, but that description fits production equipment, not consumables. Tools and machinery are capitalized as property, plant and equipment and depreciated, and depreciation on factory equipment is itself an overhead cost. Glue and nails are used up in the period and charged to overhead when they are issued.

Example: a furniture maker

A hypothetical company builds tables and chairs.

• Direct raw materials: lumber, cushions, padding and upholstery fabric. Each unit uses a measurable quantity, so the cost can be assigned chair by chair.
• Indirect raw materials: nails, fittings, wood glue and shop consumables. The amount per chair is tiny and hard to measure, so the company pools these costs in overhead.

The line between the two is a judgment about materiality and traceability. A company making a single high-value item might trace hardware directly. A high-volume plant would not bother.

Types of raw materials

One common classification groups raw materials by how they are obtained:

• Mined materials: taken from the earth, such as ores, metals, minerals, stone, lime, sand, soil, oil and coal.
• Plant-based materials: from trees and crops, such as wood, cotton, latex, resins, fruits, nuts, flowers and vegetables.
• Animal-based materials: from livestock and other animals, such as milk, meat, leather, fur and wool.

Each source involves very different operations and investment, so a company that relies on several kinds of input has to plan how to source each one.

A second distinction is between natural raw materials (unprocessed or lightly processed resources) and manufactured or semi-finished inputs (steel sheet, plastic pellets, refined chemicals, electronic components). Traded, standardized raw materials such as crude oil, copper, wheat and cotton are also called commodities.

How raw materials are accounted for

Measuring cost

Raw materials are recorded at cost, which includes the purchase price plus costs needed to bring the materials to their location and condition for use: inbound freight (freight-in), import duties and handling. Purchase returns, allowances and discounts reduce that cost. Ordinary warehousing after the materials arrive is generally expensed as incurred, unless storage is a necessary part of the production process.

When the same material is bought at different prices over time, the company needs a cost flow assumption to decide which cost moves into production. The usual methods are first-in, first-out (FIFO), weighted average and, under US GAAP only, last-in, first-out (LIFO). International Financial Reporting Standards (IFRS) do not permit LIFO.

Moving costs through the accounts

Under accrual accounting, a raw material’s cost follows the goods through four entries:

1. Purchase: debit Raw Materials Inventory; credit Cash, or Accounts Payable if bought on credit.
2. Issue to production: debit Work in Process for direct materials and debit Manufacturing Overhead for indirect materials; credit Raw Materials Inventory.
3. Completion: debit Finished Goods Inventory; credit Work in Process for the full cost of completed units, including materials, labor and applied overhead.
4. Sale: debit Cost of Goods Sold; credit Finished Goods Inventory.

All three inventory accounts appear in current assets on the balance sheet, because inventory is expected to be used or sold within the operating cycle. Material cost reaches the income statement only when the finished goods are sold. Until then it sits on the balance sheet.

Keeping the three accounts separate shows how much stock is still unconverted, how much is tied up in production and how much is ready to ship. Lumping them together would distort unit costs, reorder decisions and margin analysis.

Raw materials used: formula and example

Raw materials purchased and raw materials used are different numbers. The gap is the change in inventory.

Raw materials used = Beginning raw materials inventory + Net purchases − Ending raw materials inventory

Here, net purchases = purchases + freight-in − purchase returns and discounts. Many financial statements label the result “cost of materials consumed.”

Hypothetical example (one year, all figures in dollars):

If $10,000 of the materials used were indirect supplies, $150,000 is charged to work in process as direct materials and $10,000 goes to manufacturing overhead.

Budgeting how much raw material to buy

Manufacturers often prepare a raw materials budget within the annual production budget. It sets how much material to order so production does not stall, without tying up cash in excess stock.

Required purchases = Materials needed for production + Desired ending inventory − Beginning inventory

Hypothetical example: The furniture maker plans to build 2,000 chairs next quarter, and each chair uses 6 board feet of lumber.

• Lumber needed for production: 2,000 × 6 = 12,000 board feet
• Desired ending inventory (a buffer for the following quarter): 1,500 board feet
• Beginning inventory on hand: 2,000 board feet
• Required purchases: 12,000 + 1,500 − 2,000 = 11,500 board feet

At an assumed price of $4 per board foot, the purchase budget is $46,000. The ending buffer is a policy choice. A larger buffer protects against supplier delays and costs more to hold. A smaller one frees cash and raises the risk of a shortage.

How companies source raw materials

Most companies buy from third parties such as producers, processors and distributors, often under supply contracts. Buying creates ongoing operating expenses but avoids owning extraction or farming assets.

The alternative is vertical integration: owning the mine, plantation, farm or processing plant that produces the input. This route requires a large upfront capital investment. In exchange, it removes the supplier’s margin and can lower operating costs and supply risk afterward. Deciding between the two is a capital budgeting question, and companies commonly evaluate it with tools such as net present value (NPV).

Limitations and risks

• Price volatility. Commodity-linked inputs can move sharply with weather, extraction disruptions and demand. Rising input costs squeeze margins unless the company can raise its own prices.
• Supply risk. Reliance on one supplier or region exposes production to shortages, trade restrictions and transport delays.
• Obsolescence and spoilage. Materials can degrade, expire or become unusable after a design change. Under US GAAP, inventory measured with FIFO or average cost is carried at the lower of cost and net realizable value. LIFO inventory uses lower of cost or market. A write-down debits a loss or expense account and credits inventory, reducing assets.
• Method sensitivity. FIFO, LIFO and weighted average produce different values for materials used and ending inventory when prices change. That limits comparisons between companies that use different methods.
• Classification judgment. Whether an input is direct or indirect depends on traceability and materiality, so unit costs depend partly on management choices.

Raw materials vs. related terms

• Raw materials vs. inventory. Raw materials are one of a manufacturer’s three inventory types, alongside work in process and finished goods. A retailer’s inventory is merchandise bought for resale, not raw material.
• Raw materials vs. work in process. Materials become work in process once they are issued to production. WIP also carries the labor and overhead added so far.
• Raw materials vs. finished goods. Finished goods are completed products awaiting sale. They are raw materials only to a buyer who will process them further.
• Raw materials vs. commodities. A commodity is a standardized, interchangeable good traded in bulk. Many raw materials are commodities, but custom components and specialty chemicals are raw materials without being commodities.
• Direct materials vs. supplies. Factory supplies used up in production are indirect materials charged to overhead. Office supplies are not production inputs and are expensed as general and administrative costs.

FAQs

The Bottom Line

Manufacturers, cost accountants and investors reading inventory figures all depend on how raw materials are classified and valued. Separating direct from indirect inputs, tracking costs through the three inventory accounts and budgeting purchases against a set buffer keep unit costs and margins accurate. Comparisons between companies need care, because cost flow methods and classification judgments change the reported numbers.