Raw material costs can be difficult to manage and track accurately. Many businesses struggle to understand where these costs appear in financial statements and when they actually become expenses. Poor tracking can lead to incorrect profit figures and weak cost control.
The solution lies in understanding how raw material costs flow through accounting records. By tracking these costs as inventory first and moving them through production stages, businesses can report expenses accurately and maintain better financial control.
In this article, we’ll explore what raw materials are, how raw material costs are tracked in financial statements, the factors that influence these costs, and practical ways to manage and reduce them.
What Are Raw Materials?
Raw materials are the basic materials or substances used as the unprocessed inputs in the production or manufacturing of goods. Businesses use these materials at the start of the production process to make final products they sell.
Companies can either purchase these raw materials from suppliers or source them internally. Common raw materials include wood, steel, fabric, plastic, chemicals, grains, and metals, etc.
There are two types of raw materials companies use during production:
Direct Raw Materials
Indirect Raw Materials
Direct raw materials are the materials used directly during product manufacturing. In contrast, indirect raw materials are the materials used to support the production activities but not to build the final product itself.
For example, suppose you’re producing a dress. The fabric you’re using here is a direct raw material. And the machine oil to keep the sewing machine running or the cleaning chemicals you’re using are indirect raw materials.
4 Steps to Track Raw Material Costs in Financial Statements
Raw material costs follow a step-by-step process in financial statements. Businesses do not record these costs as expenses immediately. Instead, they track these through different accounts as production progresses before they appear on the income statement.
Review the steps below to track raw material costs in financial statement:
Step 1: Purchase of Raw Materials (Balance Sheet)
A business records purchased raw materials as inventory instead of an expense. So, they appear as current assets on the balance sheet. And the cost includes purchase price and related costs like freight-in.
At this stage, there is no impact on profit.
Step 2: Use of Raw Materials in Production
When production begins, raw material costs move out of raw materials inventory.
The materials used directly in production move to Work in Process (WIP) Inventory
The materials used indirectly are included in manufacturing overhead
Step 3: Completion of Production
After the production is complete, the total cost (including materials, direct labor, manufacturing overhead costs) moves from WIP inventory to Finished Goods Inventory. The cost is still recorded as an asset.
Step 4: Sale of Finished Goods (Income Statement)
When you sell the completed product, the cost moves from Finished Goods Inventory to Cost of Goods Sold (COGS). The COGS appears on the income statement and directly reduces gross profit. This is when raw material costs finally become an expense.
Formulas and Methods to Track Raw Material Costs
Businesses use simple inventory calculations to track how much raw material they actually consume during a period.
To track raw materials usage in production, use the formula:
Direct raw materials used = Beginning raw materials inventory + Materials purchased – Ending raw materials inventory
Businesses also apply standard inventory valuation methods to assign costs consistently to inventory and production. These methods include:
First-In, First-Out (FIFO): The earliest purchased materials are used first
Moving Average Cost: Spreads material costs evenly across units
Using MRP to Manage Raw Material Costs
Poor control over raw materials can lead to higher costs and inaccurate financial reporting. Because of this, many businesses struggle to manage raw material usage efficiently. Material Requirements Planning (MRP) helps address these challenges.
MRP is a system that helps businesses plan and control raw materials usage. It uses production schedules and sales forecasts to determine how much material is needed and when it should be purchased.
By improving inventory planning, MRP systems help businesses:
Avoid excess inventory and material shortages
Plan timely purchase and delivery of raw materials
Track raw materials as they move through inventory, Work in Process (WIP), and Cost of Goods Sold (COGS).
This makes raw material cost tracking more efficient and improves accuracy in financial statements.
Factors That Influence Raw Materials Costs
There are several factors that influence raw materials cost over time:
Changes in supply and demand
Commodity price fluctuations
Transportation and logistics costs
Import duties and taxes
Purchase quantity and bulk discounts
Storage, handling, and wastage
Strategies to Reduce Raw Material Costs
Following are the strategies businesses can manage and reduce raw material costs:
Negotiate better prices and payment terms with suppliers.
Consolidate vendors and purchases.
Reduce scrap and waste during production.
Maintain optimal inventory levels to avoid overstocking or shortages.
Use inventory management on MRP systems.
Improve forecasting and production planning.
Bottom Line
To conclude, raw materials are the foundation of any product. Businesses don’t expense these costs right away. Instead, they track them as inventory and move them through production stages. The cost shows up as an expense only when the product is sold. Tracking raw material costs correctly matters a lot as it helps businesses understand true production costs and protect their profit margins.
If you work with financial statements or corporate data regularly, using AI-powered corporate filings can save you time and effort. Tools like Global Filings help you quickly review balance sheets, income statements, and cost details without digging through lengthy reports. You can explore the platform and start a free trial to see how it makes financial analysis faster and more accurate.
Frequently Asked Questions
Are raw materials an asset or an expense?
Raw materials are an asset when a business purchases them. They appear as inventory on the balance sheet. But they become an expense only when the completed product is sold. And the cost then moves to Cost of Goods Sold (COGS) on the income statement.
What happens if raw materials are expensed too early?
If a business expenses raw materials too early, it understates profit in the current period. It also misreports inventory and Cost of Goods Sold COGS. This leads to inaccurate financial statements.
Why is tracking raw material costs essential?
Tracking raw material costs is essential because it helps businesses measure actual production costs. It also improves pricing decisions and profit analysis. Moreover, it ensures accurate financial reporting and inventory control.
How can I track raw material costs in financial statements?
To track raw material costs in financial statements, record them as inventory on the balance sheet first. Then, move the costs through Work in Process (WIP) and Finished Goods Inventory as production continues. Finally, expense them as Cost of Goods Sold (COGS) on the income statement only when the finished products are sold.
How raw material costs is different from Product costs?
Raw material costs are a part of product costs. Product costs generally include the raw material costs as well as the direct labor and manufacturing overhead costs.
Related Readings:
