Inventory consists of three components: raw materials, works in progress and finished goods. Raw materials are the inputs to works in progress and finished goods, and they consist of two types: direct and indirect materials. Direct raw materials are the actual components used to make a finished product, such as sugar that is used to make candy bars. Indirect raw materials are the materials used in the process of converting raw materials into finished products, such as disposable molds used to shape candy bars.
Raw Material Used and Raw Materials Inventory
There are two inputs into the raw material turnover ratio calculation: the value of actual materials used and the value of raw materials inventory. Both of these items can be found in the notes accompanying the financial statements that discuss inventory. In some cases, you may have access to internal accounting system reports, which can generate a manufacturing costs statement for you. The value of raw materials inventory is the ending balance of raw materials inventory. The value of actual materials used is equal to the beginning balance of raw materials plus raw materials purchased, less the ending balance of raw materials.
Calculating Raw Material Inventory Turnover
Upon obtaining the necessary inputs, calculate raw material inventory turnover by dividing the actual value of raw materials used by the raw materials inventory balance. For example, if during the fiscal year raw materials amounting to $1 million were used, and the ending raw materials balance was $200,000, the raw material turnover ratio would equal $1 million divided by $200,000, or 5.0. This means that raw material inventory balances were used and replenished five times over the course of the year. If production was erratic, you can use average raw material inventory as the denominator. This is done by adding beginning raw material inventory plus ending raw material inventory and dividing by 2.
Analyzing Raw Materials Inventory Turnover
Calculate the average number of days in inventory for raw materials by dividing 365 by the raw materials turnover ratio. For example, using a raw materials turnover ratio of 5.0, the average number of days raw material stayed in inventory during the year was 365 divided by 5.0, or 73 days. Company management uses these ratios to manage inventory use and may choose to manage inventory more aggressively by setting goals of higher inventory turnover. Meeting these goals would require increased productivity, in terms of worker productivity or using less indirect raw materials to generate the same level of finished goods.