Raw Materials Inventory: Everything You Need to Know
Learn how to calculate and account for raw materials inventory and understand best practices for raw materials inventory management.
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Raw materials inventory is the backbone of any successful inventory management process. It’s the art of finding and using your raw materials in the most efficient way possible.
You predict the current and future conditions of the supply chain to create a strategy that helps you get the materials your business needs for your manufacturing process.
It also helps you manage your warehouse efficiently, produce quality products on time, and maximize your bottom line by managing inventory costs. This is especially important for a small business looking to keep costs low, but it can be equally necessary to help large businesses stay on top of their finances.
These practices are essential. In recent years, the global supply chain has shown countless weaknesses that make it challenging to procure raw materials needed to produce excellent products.
In this guide, we’ll cover everything you need to know about raw materials inventory — including what raw materials inventory is, how to calculate raw materials value, and a few tips for handling your inventory.
- Your company uses raw materials to produce finished goods for customers. They are classified as direct and indirect materials.
- Calculating raw material inventory value and turnover will help you understand your raw materials value and how well you manage your inventory.
- Raw materials accounting helps you track your raw materials inventory and make sure you have enough stock to meet demand.
- Material resource planning (MRP) software can help you manage your raw materials inventory by making it easier to create inventory forecasting reports and manage your stock.
What is raw materials inventory?
Companies purchase raw materials — such as wood, fabric, and metal — to keep them in stock for producing finished products. Raw materials inventory refers to which materials you have on hand and their quantities.
These materials are also called pre-production inventory: what you currently have in stock and can use for production.
Raw materials lose this classification and become other types of inventory the moment you use them in manufacturing. Raw materials become work-in-process inventory materials and, eventually, finished goods.
Types of raw materials
There are two primary types of raw materials, classified by whether they make up your final product or are solely used in the process of making the final product.
Direct raw materials
These are the raw materials that will become part of your finished products. Examples include the wood an eCommerce business might use to manufacture a table or plastic to fabricate a water bottle.
Indirect raw materials
Indirect materials are those that don’t make it into your final product. You use these during production, such as cleaning supplies, disposable tools, and personal protective equipment (PPE).
How to calculate ending raw materials inventory value
To calculate your raw material inventory, you first need to gather the following information:
- Beginning raw materials inventory: The raw materials inventory you had in stock at the beginning of the accounting period
- Purchased materials: The amount of raw materials you purchased during your accounting period
- Cost of goods sold (COGS): The total cost of producing goods during your accounting period
Once you have the numbers above, use the following inventory formula to calculate your raw inventory:
Final raw materials inventory = (Beginning raw materials inventory + Purchased materials) - COGS
Let’s look at an example:
Let’s say your company has a beginning inventory valued at $100,000, you’ve purchased additional inventory of $60,000 since then, and your COGS is $120,000 for the period. You can then calculate the ending raw materials inventory value like this:
($100,000 + $60,000) - $120,000 = $40,000
Your ending inventory value is $40,000.
How to calculate raw materials inventory turnover
The next important value in your raw materials inventory calculation is your raw materials inventory turnover. This refers to the number of times your raw materials inventory was consumed and replenished during a given period.
The formula for calculating raw materials inventory turnover is:
Raw materials inventory turnover = COGS / Average raw materials inventory
To calculate the average raw materials inventory, use the following formula:
Average raw materials inventory = (Beginning raw materials inventory value + Ending raw materials inventory value) / 2
Let’s use the example from the previous calculation to calculate the turnover rate:
Average raw materials inventory = ($100,000 + $40,000) / 2 = $70,000
Now, let’s break that down into an easy-to-use ratio. Calculate the inventory turnover ratio using the formula:
Inventory turnover ratio = COGS / Average raw materials inventory
Plugging in the values:
Inventory turnover ratio = $120,000 / $70,000 = 1.71
This calculation gives you a raw materials inventory turnover of 1.71.
Using this number, you can determine if there is a discrepancy between the rate at which you’re ordering and using raw materials. A higher ratio means you’re selling products and reordering raw materials quicker, while a lower ratio means you're struggling to work through your current supply.
Raw materials inventory accounting practices
Properly accounting for your raw materials inventory will help you track them from acquisition to finished product, calculate your return on investment, and better understand your financials.
How you handle inventory accounts depends on the type of raw materials inventory you’re dealing with: direct, indirect, or unusable.
Direct materials accounting
Use your direct materials with your work-in-process (WIP) accounts. Your WIP inventory includes raw materials your team has worked on that are not yet considered finished products.
After using raw materials in production, debit the work-in-process inventory account and credit the raw materials account.
This extra step may not make sense if you have a quick production process. If that’s the case, debit the finished goods inventory account instead.
Indirect materials accounting
You won’t debit indirect materials to your work-in-process account because you don't include indirect raw materials in the final product. You use them for factory upkeep and the like.
Create a separate account for factory overhead, debiting these raw materials from that account while crediting them to your raw materials account.
Unusable materials accounting
In some cases, you may have raw materials that aren't usable anymore because of spoilage (in the case of food items) or quality degradation. Debit these materials to your COGS account and credit your raw materials inventory.
5 tips for managing your raw materials inventory
Now that you understand raw materials inventory and how it factors into your accounting practices, here are a few tips to help you manage it.
Use material resource planning (MRP) software
Material resource planning is the process that determines what materials you need for production and in what quantities.
It means using historical data and other factors — such as lead times, supply chain delays, and production times — to estimate the raw materials you need for current production and safety stock for unexpected demand and problems.
MRP software helps this process. It uses that data to help you determine how to manage your inventory and automates other time-consuming tasks.
Here are a few features you can look forward to with MRP software:
- Inventory control
- Supply chain metrics monitoring
- Production planning
- Purchase planning
- Task planning
- Data management
- Report generation
Update your safety stock levels and reorder levels
Understanding demand for your product is vital to managing your inventory level.
If you try to reduce risk by ordering too many raw materials, you’ll have too much money tied up in inventory and hurt your cash flow.
But if you try to save money and don’t have enough materials, you’ll run out of stock and won’t be able to meet customer demand.
Calculate the minimum amount of raw materials you need to meet demand and account for any unexpected situations — like demand increases or bad materials.
Understanding these factors will help you calculate your ideal reorder point and the safety stock needed to prevent raw material shortages when you need more materials than expected.
Assess industry standards
Your business likely has unique circumstances. What works for other companies in your industry may not work for yours.
At the same time, industry standards help companies know what to do at a minimum to produce quality products.
You can find insights with this information to guide your initial choices. Once you find the tactics that work for your business, start looking at what makes your company unique to create a raw materials inventory process that works for your business.
Use quality control on raw materials
Having quality materials is critical if you want to serve your customers well.
Yes, you can save cash by procuring raw materials from a low-quality supplier. But if those materials don’t result in a quality product, you’ll end up with a lot of complaints from customers and retailers.
Focus on quality and don’t allow substandard materials in your products. Purchase from quality suppliers and inspect materials when you get them to make sure they meet your standards.
Creating a quality control procedure in your warehouse to examine incoming materials is important. This can vary for every business, but here are some common tactics:
- Set clear expectations with your suppliers detailing your expected quality.
- Examine your raw materials before adding them to your inventory, separating the good from the bad.
- Note problems with any low-quality or defective materials.
- Send feedback to your suppliers so they can address issues and you can request replacements if necessary.
Focus on raw materials and finished inventory before work-in-process inventory
Any seasoned business owner knows there is much more to a raw materials inventory management system than raw materials in, products out.
Simplify the process by tracking your raw materials and finished products before considering the work-in-process inventory. What really matters is how many raw materials you have and how they turn into finished products — the steps in between are not as important at first.
Once you have a good grasp of your raw materials and finished products, you can look into your work-in-progress inventory and see how it fits into your overall inventory picture.
Take control of your supply chain with Circuit for Teams
A reliable system for managing raw materials is vital to inventory management. You must keep enough materials on hand to produce the right number of products to meet demand, understand your manufacturing costs, and adequately account for your inventory through each production stage.
But to maintain a smooth flow from procurement to production to your customer’s door, you also need a well-coordinated delivery system. That’s where Circuit for Teams can help.
Circuit for Teams offers advanced route planning and logistics optimization tools to enhance your overall supply chain efficiency. Sign up today and see how Circuit for Teams can streamline your delivery process.