Are Raw Materials Inventory? The Accounting Explained

Raw materials are a primary type of inventory for manufacturing businesses. They represent the fundamental components a company acquires for use in its production processes.

Defining Raw Materials

Raw materials are the basic substances or components a company purchases to transform into finished products during the manufacturing process. They are defined as basic materials and components used in goods production.

Examples of raw materials span various industries. For instance, a furniture manufacturer considers wood a raw material. Crude oil serves as a raw material for companies producing petroleum products like gasoline. In the food industry, flour is a raw material for baked goods, and grains or fruits are inputs for other consumable products. Silicon is a raw material in the electronics sector.

The Concept of Inventory in Accounting

Inventory, in an accounting sense, refers to assets a business holds for several purposes. These assets can be goods intended for direct sale, items currently undergoing production for sale, or materials and supplies that will be used up in the manufacturing process or while providing services. Inventory is classified as a current asset on the balance sheet, reflecting its expectation to be converted into cash or consumed within one year.

Manufacturing businesses categorize their inventory into three main types. Raw materials are the initial inputs. Once raw materials begin the transformation process, they become Work-in-Process (WIP) inventory, representing partially completed goods that require further processing. Finally, when products are fully manufactured and ready for sale, they are classified as Finished Goods inventory.

Accounting for Raw Materials

Accounting for raw materials begins when they are purchased. Upon acquisition, raw materials are initially recorded as an asset on the balance sheet, typically in a “Raw Materials Inventory” account. The cost includes the purchase price and any directly attributable costs, such as freight-in and preparation expenses. For example, if a company purchases raw steel, the cost would include the invoice price plus shipping charges.

Companies use one of two primary systems to track raw materials inventory: perpetual or periodic. A perpetual inventory system continuously updates records in real-time with each purchase, usage, or sale. This system provides ongoing visibility into stock levels and Cost of Goods Sold (COGS). In contrast, a periodic inventory system updates records only at specific intervals, often at the end of an accounting period, after a physical count.

When raw materials are moved from storage and enter the production process, their cost is transferred from the Raw Materials Inventory account to the Work-in-Process Inventory account. As production continues, direct labor and manufacturing overhead costs are added to the Work-in-Process. Once products are completed, their total cost transfers to the Finished Goods Inventory account. Finally, when finished goods are sold to customers, their cost is moved from Finished Goods Inventory to the Cost of Goods Sold (COGS) account on the income statement, where it is matched against the revenue generated from the sale.

Several methods are used to value raw materials and other inventory, impacting COGS and reported income: First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted-Average. FIFO assumes the oldest raw materials purchased are the first ones used in production and sold. This method generally results in lower COGS and higher net income during rising prices, with ending inventory reflecting recent costs. LIFO, permitted under U.S. GAAP but not IFRS, assumes the most recently purchased raw materials are the first ones used and sold. In inflationary environments, LIFO typically leads to higher COGS and lower taxable income.

The Weighted-Average method calculates an average cost for all available raw materials and applies this average to both the raw materials used and the remaining inventory. This method smooths cost fluctuations and often yields results between FIFO and LIFO. The IRS requires consistent application of the chosen method; changes typically require filing Form 3115.