Raw Materials Inventory Management: A Concise Guide for Manufacturers


Raw Materials Inventory Management: A Concise Guide for Manufacturers

Inventory management is a critical element of the supply chain for the manufacturer. The manufacturer deals with 3 kinds of inventory; raw materials, work-in-process, and finished goods inventory.

Raw Materials Inventory is the stock of material that has yet to be used in the manufacturing process. In the production process, the raw materials are used to create work-in-process inventory which in turn gets converted to finished goods inventory.

Efficient management of Raw Materials Inventory is significantly crucial to impact the bottom line of a company. It involves the systematic oversight and control of the materials used in the manufacturing process.

Importance of Raw Materials Inventory Management

The importance of Raw Materials Inventory management can be understood from the ways it impacts several critical areas of the manufacturing process.

1. Production Efficiency

Management of raw materials inventory ensures that the raw materials are available at the right time. This reduces downtime, prevents production bottlenecks, and improves production efficiency.

2. Cost Control

Maintaining optimum levels of raw material prevent both overstocking as well as under stocking. Due to overstocking inventory storage costs are increased. Under stocking on the other hand may lead to production delays.

3. Cash Flow Optimisation

By balancing requisite inventory levels, you can avoid capital from getting tied up in managing excess inventory. This helps in smoother cash flow management.

4. Quality Control

Due to regular monitoring and inspection of raw materials, quality control is ensured. Certain raw materials are also perishable. Proper management of raw materials inventory will also ensure that the perishable materials are used before their shelf life.

5. Customer Satisfaction

Adequate raw materials inventory leads to timely production and delivery of products. This boosts customer satisfaction and enhances their loyalty.

Raw Materials Inventory Accounting

A significant part of Raw Materials Inventory Management is its accounting. An accurate account of raw materials inventory helps to keep a better track of investment in inventory and provides an overview of the financial health of the company.

It is important to first understand the two types of raw materials inventory which are to be considered in its accounting. Direct raw materials inventory and Indirect raw materials inventory.

Direct raw materials inventory includes all the materials that are used in the manufacturing process and constitute the finished product. Let us take an example of a company manufacturing chairs and tables. The direct raw materials inventory will constitute wood, fabric, and padding.

Indirect raw materials inventory refers to all the materials that are consumed during the manufacturing process but are not a part of the finished product. In the above example, indirect raw materials inventory will constitute glue, nails, fasteners, and other worker tools and equipment.

Raw materials inventory is shown in the balance sheet as a current asset. Both direct and indirect raw materials acquired are initially recorded with a debit to the raw materials inventory account and a credit to accounts payable.

Calculation of Raw Materials Inventory value

Let us understand a few terms before calculating the Raw materials inventory value.

Beginning Raw Materials Inventory

It is the inventory of raw materials that you have in stock at the beginning of the accounting period. Here, the ending raw materials inventory of the previous accounting period becomes the beginning raw materials inventory of the current accounting period.

Raw materials inventory purchased

It is the raw materials purchased during the current accounting period.

Cost of Goods Sold (COGS)

COGS is the total cost of purchasing or manufacturing the products sold during a specific period. It is inclusive of all the labour, overhead, and materials costs associated with the manufacturing process.

Manufacturers are interested in calculating the Ending raw materials inventory which will become the beginning raw materials inventory for the next period.

Ending raw materials inventory can be calculated using the below formula:

Ending raw materials inventory = (Beginning raw materials inventory + Raw materials inventory purchased) – COGS

Calculation of Raw Materials Inventory turnover ratio

The raw materials inventory turnover ratio is another statistic that is important for the manufacturer to understand the rate at which the materials are used and replaced. It can be derived using the below formula:

Raw materials inventory turnover = COGS/Average cost of raw materials inventory

The Average cost of raw materials inventory can be obtained by dividing the total of beginning raw materials inventory and ending raw materials inventory by 2.

Raw materials inventory turnover ratio between 4 and 6 is considered to be ideal. A higher ratio indicates that the raw materials of a company are used and replaced frequently. A lower ratio indicates a disconnect between acquiring and using raw materials in the supply chain.

Best Practices and Tips to Manage Raw Materials Inventory

Having discussed the importance of Raw Materials Inventory Management and how to calculate useful metrics, here are certain best practices and tips for you to manage raw materials inventory efficiently:

1. Demand forecasting and planning

The foundation of effective raw materials inventory management is accurate forecasting of demand. Based on analysis of historic sales data, lead times, seasonality and market trends, etc, you can predict demand and manage raw material inventory accordingly.

Inputs from the sales and marketing team can also be incorporated to gain insights into upcoming promotions, product launches, or any market changes which may impact raw materials inventory planning.

2. Undertake ABC Analysis

All raw materials are not the same in value and criticality in the manufacturing process. It is a good practice to classify raw materials accordingly.

One of the approaches is ABC Analysis. You can divide your raw material into three categories: A represents high value-low quantity, B represents moderate value-moderate quantity and C which represents low-value and high quantity.

More attention needs to be paid to A category raw materials as they have a significant impact on the bottom line of the company.

3. Manage relationships with suppliers

Unless you produce on your own, raw materials are sourced from suppliers and a strong relationship with them is a benchmark for success. Maintain regular and cordial communication with them to ensure timely delivery and glitch-free production schedules. This will also help you to anticipate any potential supply issue in advance.

You can also consider dual or multi-sourcing for critical raw materials to reduce the risk of any disruption in the supply chain.

4. Calculate Reorder points and set safety stock levels

The level of raw materials inventory at which you need to place an order for more raw materials is the reorder point. Recorder point allows you to place orders and replenish stock on time. This is an important aspect to meet timely customer demand.

It is also advisable to maintain a safety stock level, which the extra inventory kept at hand in case of delay in the supply chain or unexpected demand spike.

Reorder points can be calculated using the following formula:

Reorder Point = (Lead Time x Average Daily Usage) + Safety Stock

Here, lead time is the amount of time it takes for the order raw materials to arrive after placing the order. Average daily usage is the amount of raw materials used daily in production.

The reorder point needs to be calculated regularly as it changes with the lead time, safety stock, and average daily usage change.

5. Integrate technology

Technology and automation ease a lot many things. Use the best technological and automation solutions to help in effective raw materials inventory management. Some of them can be:

  • Automated demand forecasting tools to accurately estimate and plan
  • Inventory management software to provide real-time visibility into raw materials
  • Automated Data-mining tool for expansive data collection and analysis of various data points such as inventory, demand, trends, order schedules, and so on
  • Use costing software to automate costing functions such as ordering costs, carrying costs, inventory holding costs, shortage costs, and spoilage costs

6. Conduct regular Inventory audits

It is a good practice to conduct regular inventory audits to identify discrepancies between actual and recorded quantities. It can be done by stocktaking and cycle counting.

Stocktaking is counting your inventory physically to verify it matches the records. It can be done once a month or at a predetermined period.

The process of counting only a small subset of inventory materials on a regular interval is cycle counting. It is generally done by smaller businesses as it is easier to implement and does not need a full-scale shutdown of inventory.

7. Focus on quality

When the input is of good quality, the final product will be of superior quality. It is advisable to use quality raw materials even if they may be expensive. In the long run, it will save expenses, ensure streamlined production, create superior products, and satisfy customers.

Final Thoughts

Raw Materials inventory management is a very critical element of inventory management for manufacturers as raw materials are what goes into a final product.

Managing raw materials inventory efficiently is a balancing act that requires planning, devising strategies, and successful execution meticulously. Manufacturers need to custom-tailor the best practices and tips to suit their specific business, product type, and operational constraints.

If you are a manufacturer, you can choose to manage raw material inventory on your own or can also outsource to a Third-party logistics provider (3PL). 3PL has the requisite expertise and experience to fulfil your expectations.

You can get in touch with us to understand how we can help to streamline your raw materials inventory management and support you in the growth of your business.

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