Most of the world’s industry involves working with raw materials extracted from the earth. As well as fossil fuels, minerals such as salt, clay and sulphur, and metals including copper and iron ore are all extracted for industrial purposes. The extraction of such materials is described as primary industry; activities that convert them into other products are known as secondary industries.
Raw materials are used in a multitude of products. They can take many different forms. The kind of raw materials inventory a company needs will depend on the type of manufacturing they do. For manufacturing companies, raw materials inventory requires detailed budgeting and a special framework for accounting on the balance sheet and income statement.
In some cases, raw materials may be divided into two categories: direct and indirect. Whether a raw material is direct or indirect will influence where it is reported on the balance sheet and how it is expensed on the income statement.
Direct raw materials are materials that companies directly use in the manufacturing of a finished product, such as wood for a chair. Indirect raw materials are not part of the final product but are instead used comprehensively in the production process.
Indirect raw materials will be recorded as long-term assets. Within long-term assets, they can fall under several different categories including selling, general, and administrative or property, plant, and equipment. Long-term assets usually follow some depreciation schedule which allows the assets to be expensed over time and matched with revenue they help to produce. For indirect raw materials, depreciation timing will usually be shorter than other long-term assets like a building expensed over several years.
Direct raw materials are placed in current assets as discussed above. Direct raw materials are expensed on the income statement within cost of goods sold. Manufacturing companies must also take added steps over non-manufacturing companies to create more detailed expense reporting on costs of goods sold. Direct raw materials are typically considered variable costs since the amount used depends on the quantities being produced.
A manufacturer calculates the amount of direct raw materials it needs for specific periods to ensure there are no shortages. By closely tracking the amount of direct raw materials bought and used, an entity can reduce unnecessary inventory stock, potentially lower ordering costs, and reduce the risk of material obsolescence.
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 expenses the inventory as a debit to write-offs and credits the obsolete inventory to decrease assets.
picture Credit : Google