What Are Raw Materials?
Raw materials are materials or substances used in the primary production or manufacturing of goods. Raw materials are commodities that are bought and sold on commodities exchanges worldwide. Traders buy and sell raw materials in what is called the factor market because raw materials are factors of production as are labor and capital.
A manufacturing company will record raw materials in the raw materials inventory account. When a company uses raw materials in production, it transfers them from the raw materials inventory to the work-in-progress inventory. When a company completes its work-in-process items, it adds the finished items to the finished goods inventory, making them ready for sale. In the balance sheet, the cost of raw materials on hand as of the balance sheet date appears as a current asset. Companies may include raw materials in a single inventory line item on the balance sheet that also includes the cost of work-in-process and the finished goods inventory.
- The primary production or manufacturing of goods requires raw materials.
- The cost of raw materials appears as a current asset on the balance sheet.
- China is estimated to be the country with the most significant supply of raw materials.
Direct and Indirect Raw Materials
Raw materials are divided into two categories: direct and indirect. Direct raw materials are materials that companies directly use in the finished product, such as wood for a chair. Indirect raw materials are not part of the final product but are instead consumed as part of the production process, like a manufacturing facility's oils, rags, and light bulbs. Companies may also classify raw materials as indirect if the total cost is immaterial. Raw materials are typically considered variable costs because the amount used depends on the quantity being produced.
Direct Raw Materials Budget
The direct raw materials budget adds the raw materials required for production to the anticipated or desired final direct raw material balance. By subtracting the amount of direct raw materials on hand at the beginning of the period, the manufacturer determines the total direct raw materials the manufacturer needs to purchase.
Raw materials may degrade in storage or become unusable in a product for various reasons. In this case, the company declares them obsolete. If this occurs, the company immediately adds the obsolete raw material's value to the cost of goods sold with an offset credit to the raw materials inventory account.
A manufacturer calculates the amount of direct raw materials it needs for specific periods to ensure there are no shortages. By changing the amount of direct raw materials bought and used, an entity can reduce inventory stock, lower ordering costs and reduce the risk of material obsolescence.
Real World Example
China is thought to have one of the world's largest supplies of natural resources. According to World Bank data, China's natural resource rent as a percentage of GDP was 1.13% in 2016. The global average for 2016 was 6.2%, the highest value was in Liberia, 49.95%, and the lowest value was in Andorra, 0%. Natural resource rent is the revenue remaining after the deduction of the cost to access those resources. The World Bank includes the sums of rent from oil, natural gas, hard and soft coal, minerals, and forest as a percentage of a country's total gross domestic product (GDP). This figure is significant because many nations derive a large portion of their GDP from natural resources, in particular, fossil fuels.