Raw Materials

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What are 'Raw Materials'

Raw materials are materials or substances used in the primary production or manufacturing of goods. Raw materials are often referred to as commodities, which are bought and sold on commodities exchanges around the world. Raw materials are sold in what is called the factor market, because raw materials are factors of production along with labor and capital.

BREAKING DOWN 'Raw Materials'

Raw materials are accounted for in an intermediate inventory account used by manufacturing companies. As raw materials are used, raw materials inventory is decreased, while work-in-progress accounts are increased. When the work-in-process items are completed, they are transferred to finished goods, and are accounted for as cost of goods sold upon sale.

Direct vs. Indirect Raw Materials

Raw materials may be divided into two major classifications: direct and indirect. Direct raw materials are materials that can be directly traced to the finished product. For example, lumber may be directly traced to a completed chair, so in this situation, lumber is a direct expense.

Indirect raw materials are items that cannot be specifically traced. An example is the wood finish placed on the manufactured chair. Although the entire drum of wood finish is evident, the specific wood finish within the drum cannot be traced to the exact location on each produced chair. Raw materials may also be classified as indirect if the total dollar amount is immaterial.

Fixed vs. Variable Costs

Another major classification that can be used to describe raw materials is "fixed or variable costs." Fixed costs relate to charges that do not vary based on inputs or production levels. Variable costs relate to charges that fluctuate based on the quantity being produced. For this reason, raw materials are typically variable manufacturing costs because they are only purchased during the production of a good. If no good is being produced, the cost is not incurred, and because it can be avoided by reducing production, raw materials are a variable cost.

Direct Raw Materials Budget

A manufacturing entity calculates the amount of direct raw materials needed for specific periods, to ensure shortages do not occur. Also, with the specific amount of direct raw materials, an entity has the ability to reduce inventory stock and security, lower ordering costs, and reduce the risk of material obsolescence. The direct raw materials budget is calculated by adding the raw materials required for production to the anticipated or desired ending balance of direct raw materials. This summation is reduced by the amount of direct raw materials on hand at the beginning of the period. The final figure is the total direct raw materials that need to be purchased.