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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 worldwide. Traders buy and sell raw materials in what is called the factor market because raw materials are factors of production, much like labor and capital.

BREAKING DOWN 'Raw Materials'

Raw materials are accounted for in manufacturing companies' raw materials inventory account. When the 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 completed 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.

Direct and Indirect Raw Materials

Raw materials may be 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 items that are not part of the final product but are 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 is calculated by adding the raw materials required for production to the anticipated or desired final direct raw material balance. The amount of direct raw materials on hand at the beginning of the period is subtracted, and the final figure is the total direct raw materials the manufacturer needs to purchase.

Raw materials may degrade in storage or may no longer be used 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.

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