Direct raw materials
Direct raw materials are all the materials that make up the finished product. For example, all the parts used to make a bed would be considered direct raw materials, from the wood to the metal frame and components like screws. Direct materials are considered a part of the cost of goods produced, which is then divided into the cost of goods sold and ending inventory.
Indirect raw materials
Indirect raw materials are materials that are consumed during the manufacturing process but aren’t a part of the final product. Things like cleaning and office supplies, disposable tools, lubricants, and tape are examples of items that could be considered indirect raw materials.
Indirect raw materials typically fall under manufacturing overhead and are added to the cost of goods sold. If only a small amount of an indirect material is used, they are sometimes reported to an expense as incurred.
2. Maintenance, Repair, and Operating (MRO) inventory
MRO inventory consists of items used to keep a manufacturing company running smoothly. MRO inventory can include employee uniforms, industrial equipment, cleaning or operating supplies, safety equipment, and any materials you use to repair or maintain manufacturing equipment.
MRO goods are vital to keeping operations running and make up a large percentage of the total purchase for factories. But, as a category, it’s often overlooked when it comes to inventory control. Every hour a factory line downtime because of a defective part costs them thousands of dollars. Many times that part isn’t in stock, so the cost to get it shipped and installed is prohibitive, or it’s not properly labored or stored — and the part takes hours to find.
When it comes to MRO purchasing, it isn’t prioritized with the same scrutiny like other inventory, such as raw materials. Manufacturers often have numerous suppliers with no coherent procurement strategy among their sites. With so many moving parts, the costs add up, and MRO costs quickly make up a significant percentage of total manufacturing costs.
To fight back against MRO cost creep, there are few best practices to consider:
- Create an efficient MRO procurement policy with approved vendors to purchase from.
- Create a central location for MRO inventory that is tracked with the same rigor as all other inventory levels.
- Renegotiate terms and prices with supply chain partners annually in an effort to prevent cost creep.
3. Decoupling inventory
Decoupling inventory includes any extra components or raw materials that enable a manufacturer to continue with production, even in the case of unforeseen supply stockouts. Inventory is typically composed of several parts that are needed before the finished product can be sold. By breaking down, or decoupling, their inventory, a manufacturer can reduce any bottlenecks and decrease the odds of production stopping completely.
Decoupling inventory is most beneficial for larger manufacturers that produce items on a mass scale. In these cases, unavailable materials can lead to a significant loss. But having stores of decoupling inventory can provide enough buffer time to damage control and find new supplies to continue production.
4. Work In Progress (WIP) inventory
All the materials used to create a finished product are considered WIP inventory. If you manufacture bicycles, all of the unfinished bikes in your shop could be considered WIP inventory.
You can also think of all the materials in use on a factory floor as WIP inventory. WIP inventory does not include raw materials sitting on the shelf or finished goods ready for sale; they’re somewhere in between, thus getting the WIP designation.
When accounting for WIP inventory, it typically gets its own inventory account entry on the general ledger and is a current asset. Costs include the raw material costs, labor cost, and factory overhead.
Calculating the WIP inventory formula can be time-consuming and tricky, so most businesses try to minimize it before a specific reporting period. Businesses that follow a Just In Time (JIT) inventory philosophy typically have very little WIP inventory.
5. Finished goods inventory
Finished goods are items that are ready for showtime. They’ve been manufactured from raw materials or purchased from a supplier, and are ready to be sold to customers. Finished goods that are purchased as completed for sale are considered merchandise by retailers.
For a given accounting period, finished goods are short-term assets because of the expectation they will be sold as soon as possible. The finished goods inventory formula is a straightforward inventory ratio that can be used to calculate the value of your goods:
Finished Goods = (Cost of Goods Manufactured – Cost of Goods Sold) + Previous Finished Goods Inventory Value
Finished goods are combined with raw materials and WIP inventory to make up the total inventory line item on a balance sheet. (Note: safety stock and cycle stock are just two alternative ways finished inventory can be classified.)