Raw Materials

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Explaining Raw Materials

Raw materials can be defined as substances or materials used in the manufacturing or primary production of goods. Generally, raw materials are natural resources such as oil, wood, and iron. Raw materials are often modified for use in various processes before they are used in the manufacturing process. Raw materials are also referred to as commodities, which are bought and sold on commodity exchanges around the world.

Raw materials are sold in what is known as the factor market. This is due to the reason of raw materials being factors of production in addition to labor and capital. Raw materials play an important role in the production process to a great extent as the success of the economy of a country is determined by the amount of natural resources held by a country within its borders. A country holding ample amount of natural resources does not require importing of as many raw materials.

Sourcing and Processing of Raw Materials

After the raw materials have been selected, it becomes important to select the right processing technology for the same. Besides, it is also important to decide upon the source of raw materials. All these requirements can be met either through domestic sources or can also be imported related to regulatory requirements of the Governments.

Moreover, it is also important to do a careful analysis about the cost and benefit before proceeding with the process of placing orders to mitigating the production cost thus increasing the profit margins.

However, there are certain points which require consideration while selecting the processing technology. These include:

  • The level of complex machines or skilled workers required during the process.
  • The quantity of power or water required.
  • Check whether any process or product patent is required in order to utilize the opted processing technology.
  • Check whether any special environmental or pollution regulation is required to be followed.
  • The aptness of the technology to the existing environment and conditions.

In addition to these considerations, it is also important to carry out proper planning as non-availability of the requisite raw materials might result in holding production, and idle machinery and manpower. Besides, ordering too much in advance can result in locking up the working capital.  

Raw Materials under IFRS and US GAAP 

The definitions of raw materials are comparable in International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP).

Raw materials are the basic materials and components that are used in the production of goods. These materials may be in their natural state or have gone through some processing, but they have not yet been transformed into a finished product. Examples of raw materials include wood, iron ore, crude oil, cotton, and wheat.

Raw materials must be recorded at the lowest of cost or net realizable value under IFRS since they are regarded as inventory. The purchase, conversion, and other expenditures needed to bring the inventory to its present location and condition are included in the cost of raw materials. The estimated selling price less any anticipated completion, disposal, and transportation charges results in the net realizable value.

Raw materials are classified as inventory under US GAAP and are reported at the lowest of cost or market value.
The costs associated with purchasing, producing, and incurring additional expenses to get the inventory to its present location and state are included in the cost of raw materials. Market value is equal to the lowest of replacement cost or net realizable value.

In conclusion, raw materials are evaluated identically under IFRS and US GAAP and must be reported at the lower of cost or market value under both standards. The fundamental distinction is between how market value is determined under US GAAP and how net realizable value is determined under IFRS. 

Where are Raw Materials Reported on the Balance Sheet?

Raw materials are reported on the balance sheet as part of the current assets section, under the category of inventory or stock. Inventory is a current asset because it is expected to be converted into cash within one year or the operating cycle, whichever is longer.

Under the inventory category, companies may also report other types of inventory, such as work-in-progress and finished goods. Raw materials are specifically the basic materials and components that have not yet been transformed into a finished product.

The balance sheet will typically show the value of raw materials at the lower of cost or market value, in accordance with the applicable accounting standards (such as IFRS or US GAAP). The cost of raw materials will include all direct and indirect costs incurred to acquire, transport, store, and prepare the materials for use in production.

Overall, the reporting of raw materials on the balance sheet is important for investors and analysts to understand a company's ability to produce goods and the potential impact of inventory levels on cash flow and profitability.

Overstock of Raw Materials

Raw materials overstock refers to a situation where a company has excess or surplus raw materials in its inventory, beyond what is needed to support its operations. This may occur due to factors such as overproduction, changes in demand or production processes, or errors in inventory management.

Raw materials overstock can have a negative impact on a company's financial performance and operations. Some of the potential consequences of raw materials overstock include:

  1. Tying up capital. Excess inventory ties up working capital and can lead to cash flow issues if the inventory cannot be sold or used efficiently.
  2. Storage costs. Raw materials require storage space, and excessive inventory levels can increase the company's storage costs.
  3. Obsolescence. Raw materials are subject to obsolescence, particularly if they have a limited shelf life or are no longer needed due to changes in production processes or product demand.
  4. Decreased efficiency. Excessive inventory can lead to production delays, inefficiencies, and increased risk of waste or spoilage.

To avoid raw materials overstock, companies can use a variety of strategies such as demand forecasting, just-in-time inventory management, and regular inventory monitoring and analysis. It is important for companies to have a good inventory management system in place to optimize their raw material levels and avoid the negative consequences of overstocking.

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