What’s raw materials inventory?

Maintaining an efficient and effective inventory of raw materials is vital for the smooth operation of any business.

What is raw materials inventory?

Raw materials inventory is the total cost of a manufacturer’s components, subassemblies, and supplies in stock that are not currently in production. There are two types of raw materials that go into making a final product:

·???????? Direct materials (DM)

·???????? Indirect materials (IM)

Direct materials

Direct materials are the components that are part of your final product. For example, direct materials are:

·???????? Leather used to manufacture leather?bags.

·???????? Wood used to manufacture Furniture.

·???????? Copper used to manufacture electronics.

Indirect materials

Indirect materials are the components that are not part of your final product but are used during the?manufacturing process. Examples of indirect materials are:

·???????? Glue

·???????? Oil

·???????? Cleaning supplies

·???????? Disposable tools

·???????? Light bulbs

Why is raw material inventory management important?

Raw material inventory management is the process you or your managers will follow to ensure enough stock on hand, from direct materials to indirect materials, to keep production moving.

As your orders increase, you may order a ton of extra materials, if the more?safety stock?you have, the better.

Without a proper raw materials inventory plan in place, you will drive up your?manufacturing costs?for no good reason.

Your raw materials may not spoil like supermarket produce, but the result of keeping large amounts of raw material stock around is the same. That’s why it’s important to understand your raw materials’ value and customer demand.

Accounting for raw materials inventory

?Managing raw materials inventory is crucial to effective supply chain and financial management. In?manufacturing accounting, raw materials are considered a key asset for businesses. Accounting for raw materials inventory involves tracking and valuing the materials used in production.

One fundamental practice is the use of a?perpetual inventory system. This system enables real-time?tracking of raw material?quantities and costs, accurately reflecting the current asset value. Regular reconciliations between physical inventory and accounting records help identify discrepancies and prevent errors in financial reporting.

The?first-in, first-out?(FIFO) and moving average cost methods are commonly employed for raw materials inventory accounting. Under the FIFO method, the assumption is that the initial materials procured are the first to be utilized in the production process. This approach aligns seamlessly with the flow of goods in manufacturing, ensuring that the value attributed to the inventory on the balance sheet accurately reflects the current cost of the materials in stock.

The?moving average cost?method calculates the average cost of the materials on hand, incorporating the costs of all units, whether newly acquired or previously in stock. The moving average cost provides a dynamic and continuously updated valuation of the raw materials, offering a more fluid reflection of their current value in the inventory.

Both FIFO and moving average cost methods contribute to effective inventory management and precise financial reporting.

Implementing these best practices in raw materials inventory accounting enhances financial accuracy and enables businesses to make informed decisions about production, procurement, and overall resource management.

How to calculate raw materials inventory value

Regardless of their factory floor size, businesses will need to account for their raw materials, business supplies, and finished products.

To do this, you’ll need to determine the ending inventory value at the end of each period. You need to add the number of units you manufactured and the raw materials you purchased during the period to the number of units at the beginning of a period. With that said, here is the raw materials inventory formula to help you calculate this:

Let’s imagine you’re a shoe manufacturer and want to account for the number of laces you have:

50 laces + 100 laces = 150 laces

Now, subtract that number from the amount of inventory you used during this period to calculate your ending inventory. You used?60 laces?during production:

150 laces – 60 laces = 90 laces

Time to uncover the value of your remaining inventory. Simply multiply your remaining inventory by the cost of one unit of raw material:

90 laces x $1.50 = $135

And there you have it. The remaining raw materials inventory formula value comes in at?$135.

A relatively easy raw materials inventory formula to follow when calculating the value of your raw materials. However, what about those of you who have different materials or even make products at different prices? It can be complicated to calculate the value for each different item.

Try calculating your raw materials inventory value yourself following this formula:

Beginning raw materials inventory =?(COGS + ending raw materials inventory) – raw materials inventory purchased

How to calculate the raw material value with weighted average costing

To calculate your raw material inventory value using weighted average costing, you just need to follow a simple formula. So, let’s imagine you sell two products, A and B:

·???????? Product A costs?$4?and sells at a rate of?80%

·???????? Product B costs?$2?and sells at a rate of?20%

The formula for this scenario will look like this:

($4 x 0.8) + ($2 x 0.2) = $3.60

How to calculate raw materials inventory turnover

The raw materials inventory turnover ratio is a measure of how efficiently a company uses its raw materials in the production process. To calculate it, you need two pieces of information:

·???????? Cost of goods sold?(COGS) —?The total cost of all the raw materials used in production during a specific period. It includes the cost of materials that were transformed into finished goods.

·???????? Average raw materials inventory —?Calculated by adding the beginning inventory of raw materials to the ending inventory of raw materials and then dividing it by two. This gives you an?average inventory?value over the period.

Once you know both values, you need the formula for calculating the raw materials inventory turnover:

Raw materials inventory turnover =?COGS / average raw materials inventory

The result tells you how many times the company’s raw materials inventory is used and replaced over a given period. A higher turnover rate indicates efficient use of materials, while a lower rate might suggest?overstocking?or inefficiencies in the production process.

Best techniques for raw material inventory management

When you start to optimize your raw material inventory management, here are some tips and tricks to get you started on your journey.

Don’t obsess over work-in-progress inventory

Typically, companies start with finished product inventory tracking, implement basic raw material stock management, and more complex work-in-progress (WIP) management.

Although proper inventory management has great benefits, it also comes at a cost — it takes a lot of time and resources to?track your WIP?inventory. Thus, if possible, start with basic raw materials management and do not try to track different stages of production immediately.

Update safety stock and reorder points

Safety stock describes the inventory a business keeps in the warehouse to protect against spikes in demand or shortages in supply.

A good reorder point ensures that your business typically does not dip below your safety stock levels. Most businesses employ some minimum inventory principles for raw materials used in production. Manufacturers often fail to calculate raw materials used regularly. As a result, these raw materials inventory levels become inconsistent.

All the events below should trigger an adjustment:

·???????? A significant change in sales volume

·???????? Major changes in supply?lead times

·???????? A change in production volumes

Also, don’t forget to adjust safety stock and reorder points to account for seasonal changes like an upcoming holiday season.

Keeping these levels up to date ensures you always have just the right amount of raw material inventory in your warehouse so that you won’t have too much cash tied up.

Don’t try to put all materials on your BOM

Having proper raw materials management in place does not mean you should track every material consumed in your production.

For example, several indirect materials could be consumed during the production process (nails, screws, buttons, and so on) that do not cost a lot and are typically purchased by the box in high volumes. It often makes sense not to have such materials on your?bill of materials?(BOM).

Instead, cost them at the time of purchase and do not try to track every piece consumed in production.

Getting the high-cost raw material stock in place on a BOM is important so you know early on if this is a profitable product. Don’t spend hours saving pennies. Focus on what has a greater effect on your margins.

Use industry-standard metrics to find out what works for you

Your business is unique, and what works for one business might not work for another.

The basic guiding principles of this are simplicity, directness, and freedom. There is no dogmatic loyalty to one technique. This is the key to overcoming any challenging situation for your business. Take what works and discard the rest.

The key for you is to use all the tools at your disposal to form your unique style of manufacturing. You can find the secret formula to your optimal raw materials inventory game.

How much energy needs to go into raw materials inventory management?

?Have you heard of the Pareto Principle? The?famous 80/20 rule?is that 80% of the results come from 20% of the input. You could be working your socks off for 100 hours a week, but only 20 of those hours get most of your results.

What’s more, 20% of the stuff you learn about managing your raw materials inventory is used for 80% of your operations. And guess what? This 20% is the tried-and-tested fundamentals that go to the heart of inventory management. Get your foundation right, and the rest will follow. Most disciplines have a core set of principles to learn that will put you at the top of the game if you take the time to master them.

Are you spending too long on?stocktaking, only to find mistakes still happen?

The perpetual inventory workflow could be a better solution for your inventory management. Calculate how much you pay to keep each square foot of stock monthly. You could adopt the principles of?just-in-time (JIT) inventory.

We recommend you don’t go for 100% JIT at this stage.

Find out what raw material stock you have lying around the longest and ask yourself, “Why does this need to be here?” Your?inventory turnover ratio?(IRT) should be increased by keeping less stock. There’s no need to keep raw materials hanging around for months on end.

If your IRT is low, you could lose a good deal of money each month on carrying costs.

Why raw materials inventory management is vital for manufacturers?

Imagine you were going on a round-the-world trip.

You could take two large suitcases filled with clothes for every weather condition. You might think you’re smart because you’re prepared for anything, but it’ll weigh you down and cost more to transport.

Contrast this to a single backpack:

·???????? You save money on baggage fees

·???????? You can run for a bus at short notice

·???????? It makes it easier to hitchhike.

Bringing two suitcases seems less risky, but the movement is slower and is less effective overall.

The second option is the road to success:

·???????? You haven’t put all your eggs in one basket

·???????? You can change direction at a moment’s notice

·???????? Take a route that makes the most sense without disrupting plans

This type of thinking goes for keeping extra raw material inventory lying around.

Broadly speaking, as a manufacturer, you handle four different types of inventories:

·???????? Raw materials inventory

·???????? Work-in-progress

·???????? Finished products

·???????? MRO inventory

The average time a business focuses on each type of inventory changes at different stages in the business’ life.

During the startup stage, companies tend to focus more on finished products. This makes a lot of sense, as getting products to customers is the top priority. You must make a name for yourself, and your product is everything.

As the business grows, the focus might be on manufacturing and?inventory management efficiency. What was once barely a concern for the business owner becomes the number one thing on their mind.

Overcoming challenges with raw materials inventory management

here are some things you’ll need to consider when improving your raw material inventory management.

Planning and forecasting

Improving your raw material inventory management is one thing, but having a dynamic management system that considers your?demand planning?will help you maintain ideal inventory levels.

Data-driven management

Having the right amount of raw material stocked when needed is only possible by collecting data from your sales, production lines, and anywhere else on your supply chain. It is possible to do it with?inefficient spreadsheets. However, it can be difficult to make constant manual updates.

Costing

You might know how to calculate the value of your raw materials, but that doesn’t mean you can accurately track how much it costs to manufacture your products.

Other costs you need to track include?manufacturing overheads?and labor used in production. Due to various factors, these costs often change (meaning items in your inventory don’t have the same value as others). Tracking these costs alone will be extremely time-consuming and difficult.

Many manufacturers turn to?ERP manufacturing software?to help automate and track their raw materials inventory.