In accounting, one of three classes of inventory is raw materials. It consists of all the component parts that your company hasn't turned into either finished goods or works in progress. Your raw materials inventory also includes indirect materials, such as lubricants or rags that you use when creating finished goods. Knowing your raw materials inventory is important for accounting and also for business efficiency.
TL;DR (Too Long; Didn't Read)
To get the ending raw materials inventory for an accounting period, you add the beginning balance together with any raw materials purchased. Subtract the materials that were used in manufacturing, whether the goods are finished or still work in progress. This gives you the ending raw materials inventory, which is the beginning inventory for the next period.
Raw Materials Inventory Formula
Raw materials can be any sort of components: electrical switches, nails, paper for books, flowers for perfume. The raw materials inventory formula says that when you purchase raw materials, you debit your raw materials inventory asset account and credit accounts payable. If you use up $100 of materials, you'd credit $100 to the raw materials account and debit $100 to works in progress or finished goods.
For a raw materials inventory example, assume you start the quarter with $20,000 in raw materials inventory. You purchase another $16,000 of materials, increasing the inventory asset account to $36,000. You use $25,000 worth of materials during the quarter, adding $25,000 to the works in progress and finished goods accounts while reducing raw materials inventory to $11,000.
If you used $600 in indirect materials, you'd subtract that amount from the raw materials inventory and add it to factory overhead. At the end of the quarter, you use the raw materials inventory formula to establish the ending raw materials amount and then use that as the next quarter's beginning inventory.
Obsolete Raw Materials
Obsolescence can complicate your calculations. If you don't use up your raw materials inventory, you may wake up one morning and find that you can't use them. Perishable materials may have degraded in the warehouse, or your company may have changed its standards so that the materials are no longer of interest.
If this happens, subtract them from the raw inventory account and debit cost of goods sold. Suppose you have $5,000 of raw materials, buy $5,000 more in the period and use up $4,000. If $2,000 of the remaining materials become obsolete, your ending balance is $4,000, which will be the beginning balance of the next quarter.
Accounting for Raw Materials
You calculate and record beginning inventory so that you can calculate ending inventory. If, say, you're making out your balance sheet, you'll need to include inventory levels as an asset. It's acceptable accounting practice to combine raw materials, works in progress and finished goods into a single balance sheet asset account.
Total beginning inventory is also important for calculating the cost of goods sold. Add together the initial value of raw materials, works in progress and finished goods to get beginning overall inventory. Add raw materials purchases during the period and subtract the ending inventory balance. That gives you cost of goods sold, which helps determine your income for the period.
Averaging the beginning and ending inventory levels can help you generate other financial statistics, such as inventory turnover.
How Much Is Too Much?
Tracking your raw materials inventory and making a raw materials consumption analysis is also important outside of your bookkeeping. The more materials you stockpile but don't use, the greater the risk of spoilage. You also have to pay for space to store them plus possible maintenance and transportation costs.
Too little is also bad: If you don't have enough inventory to meet a rush of demand, you may miss out on sales. Reviewing past inventory levels can give you an idea of the trigger point at which you absolutely have to reorder to meet demand. Revisiting levels regularly helps you spot changes in demand that might indicate that you need to reset your benchmarks.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com