Raw Materials Inventory: Formula, Types, and Best Practices

If you build the products that you sell—or assemble them from parts—you’re in the raw materials management business. 

Raw materials are the components and unfinished goods you combine to create finished products via manufacturing. For example, wax to make candles or flour to bake bread. Raw materials also encompass items used in manufacturing, like sandpaper for smoothing wood needed to make furniture.

Determining your raw materials inventory value is critical. By integrating accounting and inventory control systems, your business can develop procedures for inventory forecasting that help you meet customer demand. Here’s how it works.

What is raw materials inventory?

Raw materials inventory refers to all the components, ingredients, and unrefined materials a business has in stock for the production process. 

These unprocessed materials are part of the first stage of the inventory life cycle. Once they enter production, they become works-in-progress (WIP), before ultimately reaching their final destination as finished goods ready for sale. 

Proper inventory management requires accounting for these raw materials as they enter your supply chain and undergo the manufacturing process.

Direct materials vs. indirect materials

A company’s raw materials inventory is typically classified into direct raw materials and indirect raw materials. Direct raw materials are eventually physically incorporated into a final product. Indirect materials are materials used in the production process that are not included in a specific finished product.

Examples of direct materials include fabric used to make clothing, steel used in manufacturing appliances, and wood used to produce furniture. Examples of indirect materials include lubricants for machinery, glue for woodworking, cleaning supplies for a sterile workplace, or protective equipment worn by workers. Disposable tools, like single-use paintbrushes, also count. These materials are known as maintenance, repair, and operating (MRO) supplies, and they are recorded as part of the total cost of goods sold (COGS) on an income statement along with direct materials.

When it comes to financial reporting, most businesses list direct materials as inventory on a balance sheet. Indirect materials, which typically account for a minor share of COGS, are sometimes expensed as overhead. To keep accurate records in accordance with accounting best practices, it’s wise to have a separate raw materials inventory account in your inventory systems and accounting books.

Why is raw materials inventory management important?

Raw materials inventory management is important because it directly affects a company’s ability to produce goods efficiently, control costs, and meet customer demand. Here’s a breakdown of exactly why efficiently managing raw materials inventory is vital for manufacturing businesses:

• Prevents production delays and stockouts. Proper management ensures that you have enough raw materials to maintain your production schedule, avoiding costly downtime and missed customer orders.

• Controls inventory costs and protects margins. You can reduce excess inventory, storage costs, waste, and spoilage by adjusting your raw materials count to match customer demand. This helps your business maintain healthy profit margins.

• Improves cash flow. Efficient inventory management prevents too much capital from being tied up in unused raw materials. You can reallocate this capital toward other initiatives like hiring, expansion, and marketing.

• Supports accurate materials planning. Well-run manufacturing businesses enjoy accurate forecasting, clear scheduling, and coordination across operations. You can improve all of these components by giving your team clear visibility into raw materials inventory levels—whether that’s a sales team pitching product shipments to retailers or the manufacturing team planning its next production run.

• Reduces risk from supply chain disruptions. Tracking raw materials inventory helps you cope with shortages, manage supplier lead times, and respond more effectively to disruptions.

• Maintains product quality and consistency. The quality of your finished goods inventory depends on the quality of your raw materials inventory. Proper sourcing of raw materials helps ensure that you don’t use old, deteriorated, or obsolete inventory in your production lines.

How to calculate the value of a raw materials inventory

Use this formula to calculate the value of your raw materials inventory during a specific accounting period:

Beginning raw materials inventory value + Purchases – Value of raw materials used = Ending raw materials inventory value

Here’s a step-by-step approach to leveraging this raw materials inventory formula:

1. Determine your beginning raw materials inventory. The value of your starting inventory is carried over from the previous reporting period (last month, quarter, or year). This is the ending raw materials inventory from your last report.

2. Add in purchases of new raw materials. You will spend money to replenish your stock as it’s used by production. Total all the invoices for direct materials and indirect materials purchased during this timeframe. For full financial accuracy, include the shipping and insurance costs associated with getting the materials to your warehouse, as these add to the materials’ value.

3. Subtract the value of the raw materials used in production. This is the value of the materials you actually moved from the warehouse to the production floor (becoming a work-in-process for the next phase of the inventory life cycle). It’s easy to get this information if you use inventory management software that logs every time a component is scanned for use in production.

This three-step calculation gives you the value of your ending inventory and is part of the current assets on your balance sheet.

How to calculate the raw materials inventory turnover ratio

The raw materials inventory turnover ratio measures how many times a company uses and replaces its supply of raw materials during a specific period. The formula for the raw materials inventory turnover ratio is:

Cost of goods sold / Average cost of raw materials inventory = Raw materials turnover ratio

To use this equation, you must also find your company’s average cost of raw materials inventory. You can determine this number with the following equation:

Average cost of raw materials inventory = (Beginning raw materials inventory + Ending raw materials inventory) / 2

Imagine a shoe manufacturer wants to calculate the raw materials turnover ratio for rubber soles. Let’s say that during the third quarter, the company started with $20,000 worth of rubber soles and ended with $40,000 worth. Its average cost of raw materials inventory would be:

$20,000 + $40,000 = $60,000 / 2 = $30,000

In this same quarter, the company sold thousands of finished shoes with a total COGS of $68,000. So plugging those figures into the formula results in:

$68,000 / $30,000 = 2.267

In other words, the inventory turnover ratio is 2.267 times during the period.

For an ecommerce business that manufactures its own products, a ratio of between four and six suggests operational efficiency, effective inventory management, and strong product performance. A ratio of less than four might indicate overstocking or a slowdown in sales and revenue generation. This means this hypothetical example falls below the ideal raw materials inventory turnover ratio. One response to a low ratio is to slow or halt your production cycle until you can sell some of your excess stock of finished goods.

Best practices for raw materials inventory management

• Track raw materials in real time or on a regular schedule
• Perform regular cycle counts
• Use historical data for more accurate demand forecasting
• Maintain appropriate safety stock levels
• Leverage industry knowledge and supplier insights
• Be consistent in your inventory valuation methods

By maintaining tight control of the basic materials that power your manufacturing, you can meet demand while also keeping your finances healthy by avoiding holding excess raw materials. Here are six tips for successfully managing your raw materials.

Track raw materials in real time or on a regular schedule

Whether using perpetual inventory systems (that monitor inventory in real time) or periodic inventory systems (that track inventory at set intervals), it’s essential to consistently track raw materials from receipt through production to preserve inventory accuracy and prevent shrinkage or miscounts.

Perform regular cycle counts 

If you opt for periodic inventory checks, aim for frequent cycle counts. These frequent checks help you validate system records against physical inventory, catch discrepancies early, and maintain reliable stock levels. Inventory management software can let you monitor these levels without resorting to full shutdowns to count stock, which can delay production.

Use historical data for more accurate demand forecasting

For most companies, accurate demand forecasting relies on analyzing historical data, seasonality, and order trends to determine optimal reorder points. This helps reduce both overstocking and understocking.

Maintain appropriate safety stock levels

Just as you would hold safety stock of finished products for customer sales, you also need it for the critical basic materials that feed your production lines. This prevents production stoppages caused by supplier delays or demand spikes. Historical data will help you determine when your safety stock crosses into the category of overstock—something to avoid because it results in additional carrying costs.

Leverage industry knowledge and supplier insights

Seasoned manufacturers apply their industry knowledge of typical lead times, price volatility, and material usage patterns to plan smarter purchases of materials and guard against risks.

Be consistent in your inventory valuation methods

Consistently apply the same valuation methods when assessing your inventory. This helps ensure more stable inventory valuation, especially when raw material prices fluctuate. It also makes it easier for you to compare beginning inventory and ending inventory across reporting periods. For example, you can consistently use weighted average costing, an inventory valuation method that calculates a single average unit cost by dividing the total cost of goods available for sale by the total number of units available.