1. What are raw materials?

Cost of raw materials: How to calculate and reduce

Navigating the cost of raw materials is a major challenge for businesses, big and small. Whether you're crafting boutique candles or building high-tech gadgets, understanding and managing these costs can significantly influence your bottom line. 

Did you know that fluctuations in raw material prices can alter product costs by up to 50%? Calculating these expenses accurately and finding ways to reduce them without compromising quality is more art than science. 

In this guide, we'll explore practical strategies to calculate these costs effectively and reduce them smartly, ensuring your business stays competitive and profitable.

Main takeaways from this article:

  • Understand the essentials of raw material costs, the major determinants, and their significance to your business's financial health.

  • Whether you want to buy or sell raw materials, learn practical methods for calculating their cost and understand how variations in these costs can impact your bottom line.

  • Identify and implement strategic measures to reduce raw material costs, including streamlining the production process and effective inventory management.

  • Realize the importance of embracing technology, overcoming resistance to change, and conducting comprehensive data analysis to achieve operational efficiency and cost savings.

  • Learn how GelatoConnect can optimize stock levels and reduce material costs through its automated procurement and analytics features.

What are raw materials?

Raw materials are the basic, unprocessed inputs used in the manufacturing of goods. These materials are transformed through production processes to create finished products. Examples include metals, plastics, textiles, and wood, essential for industries ranging from construction and automotive to fashion and electronics.

Direct raw materials vs. indirect raw materials

Direct and indirect materials

When discussing raw materials, it's crucial to understand the distinction between direct and indirect raw materials. 

Each type plays a different role in the manufacturing process, and their costs can significantly influence a company's bottom line and supply chain

Here, we explore both categories' specificities, pros, and cons. 

1. Direct Raw Materials 

Direct raw materials are those essential components directly utilized in manufacturing the final product. Their presence can be readily identifiable in the end product. 

  • Example: In producing a wooden chair, the wood used is a direct raw material because it forms the primary substance in the finished product.

  • Pros: Tracking and calculating the cost of direct raw materials are straightforward because their usage directly correlates to the product output.

  • Cons: The disadvantage, however, is that any increase in the direct material cost can significantly impact overall production expenses.

2. Indirect Raw Materials 

Your production processes may also involve materials that are not part of the final product but the creation. These are termed indirect raw materials. 

  • Example: In the same production of the wooden chair, the sandpaper used for smoothing the surface, or the paint used for its final finish, would be indirect raw materials. They contribute to the production but don’t integrate the chair structure.

  • Pros: The advantage here is that their costs are much lower and tend not to negatively influence the final product cost. They also offer room for price negotiation and substitutions.

  • Cons: There are downsides associated with procurement costs and inventory management. Finding quality yet affordable indirect materials can be quite a task.

Factors influencing the cost of raw materials

Determining the unit cost of raw materials doesn't just involve pinpointing the price per unit acquired from suppliers; many dynamic factors weave together to shape the total expenditure captured on a company's balance sheet. 

Let's delve into the most prominent factors: 

  1. Global market conditions: Global markets profoundly influence raw materials prices. For example, increased demand for electric cars could lead to a spike in lithium prices, a critical raw material for battery production.

  2. Taxes and customs: Procurement isn't just about purchasing; it includes navigating the complex terrain of taxes and customs charges. For instance, import duties and value-added tax (VAT) are typical consumption taxes that inflate the cost of procured goods from overseas.

  3. Logistics: How you transport your raw materials can significantly impact overall costs. For example, air freight offers speed but considerably higher prices than sea freight. In contrast, while cheaper, sea freight is a slower mode of transport and could result in higher inventory holding costs.

  4. Quantity of purchase: Businesses can leverage economies of scale to reduce per-unit costs. Bulk buying often leads to lower prices, but it's a delicate balancing act. Overstocking can lead to increased warehouse expenses and the risk of spoilage or obsolescence, particularly for perishable or trend-sensitive items.

  5. Supplier relations: Building a good rapport with suppliers can sometimes result in better price negotiations, favorable payment terms, and more reliable delivery, reducing overall costs.

Pro tip: These factors can fluctuate depending on supply chain disruptions, adding to the price volatility of raw material costs. That's why regularly tracking them gives a clear picture of how much you're spending, helping to ensure your business remains financially fit and competitively agile.

The importance of understanding your raw materials costs

Evaluating raw materials

Understanding the cost of your raw materials is a pivotal aspect of successful manufacturing and product development. It's like knowing the bloodline of your manufacturing process - a vital component that directly impacts your company's financial health.

Let's look at a few more reasons why understanding your raw materials costs is important.

  • Improved forecasting and budgeting: Knowledge of raw material costs facilitates better budgeting and economic forecasting. For example, suppose a furniture manufacturer has accurate data on the price of timber and other materials. In that case, they can predict production costs for future projects with more certainty, allowing for more informed decision-making on pricing and profitability.

  • Negotiation leverage with suppliers: A sound understanding of your raw materials costs can provide a significant advantage when negotiating prices with suppliers. For example, if a bakery knows the market price of flour and other ingredients, they can leverage that knowledge to negotiate better prices or search for more cost-effective sources.

  • Effective inventory management: Accurate knowledge of raw materials costs directly assists in managing inventory levels effectively. For example, a clothing manufacturer, cognizant of cotton price trends, can strategically purchase and stockpile cotton when prices are low, enabling them to maintain optimal inventory levels while reducing costs.

  • Informed product pricing: Information on raw materials costs can impact a company's pricing strategy. A thorough understanding of these costs ensures that selling prices adequately cover production costs and yield profitable margins. For example, a jewelry maker who knows the current market price of gold and gems can appropriately price their pieces to secure a profitable return.

  • Strategic planning and decision-making: Awareness of raw material costs allows for strategic planning and decision-making. This knowledge can guide companies in exploring alternative materials or techniques to lower costs. For example, a bike manufacturing company, recognizing a significant rise in the price of steel, could explore using aluminum or another comparable but cheaper material to maintain profitability.

Pro tip: Grasping the cost of your raw materials is not just valuable, it's essential. With accurate data, businesses can forge successful paths toward profitability, harness cost-saving opportunities, and drive innovation in their respective industries.

How to calculate raw material costs

Calculating material costs

Understanding how to calculate the cost of raw materials is fundamental to managing your expenses and maximizing your profit margin efficiently. This process may seem complex, but by breaking it down, it becomes more approachable. 

Let's walk through the steps involved in computing your raw material costs: 

  • Identifying direct raw material costs: You need to determine your direct raw material costs - the actual cost of raw materials used to manufacture your product. For instance, if you manufacture 100 chairs and each requires $10 worth of wood, your total direct raw material cost would be $1,000.

  • Including indirect raw materials: These are materials not directly part of the end product but necessary for its production, like cleaning supplies for your equipment. If you spend $200 on cleaning supplies to produce those 100 chairs, you would include this in your total raw material cost.

  • Adding procurement costs: Remember to include the expenses involved in obtaining your raw materials, such as shipping and handling fees, taxes, customs charges, etc., which is part of the Total Cost of Ownership (TCO) Analysis, offering a more accurate picture of your actual costs. Suppose your procurement costs for the wood and cleaning supplies were $150; add this to your raw material cost.

  • Calculating inventory carrying cost: The next step is to factor in the inventory carrying cost, which includes the cost to store, insure, and handle your raw materials. These costs amount to $50 for those 100 chairs.

  • Total raw material cost: Finally, add up your direct raw materials, indirect raw materials, procurement costs, and inventory carrying costs to arrive at your total raw material cost. Following our example, this would be $1,000 (direct) + $200 (indirect) + $150 (procurement) + $50 (carrying cost) = $1,400.

Strategies to reduce raw material costs

Reducing material costs

Reducing raw material costs is multi-faceted and requires strategic planning and execution. It typically involves a deliberate focus on lowering procurement expenses through various strategies. 

Here are some practical approaches: 

  • Negotiate better deals: Initiate negotiations with suppliers to achieve better pricing. Leveraging your buying power and promising more extensive orders or long-term contracts can often sway suppliers into offering more competitive rates.

  • Consolidate vendors and deliveries: Consider consolidating orders and deliveries and reducing the number of vendors. This approach can help you qualify for quantity discounts, streamline ordering processes, and cut transportation costs.

  • Review contracts regularly: Ensure frequent contract reviews. Continuous monitoring can help spot hidden charges, quality issues, or inefficiencies that may quietly inflate costs.

  • Prevent maverick spending: Maverick spending involves purchases made outside of agreed contracts or without following the purchasing process. Establish clear procurement policies and educate the staff to minimize these expenses.

  • Applying low-cost country (LCC) sourcing: Many businesses can substantially reduce raw material costs by sourcing from low-cost countries. For instance, opting for garments from Bangladesh instead of Italy could bring significant savings. However, concerns about quality control, ethical sourcing, and possible tariffs should be well-managed in such cases.

  • Maintain optimum inventory levels: Holding too much stock increases capital and leads to storage costs, whereas too little can disrupt production. Use business analytics and tools like GelatoConnect's automated procurement feature to calculate the optimum inventory level for each resource.

  • Development of supplier relationships: Strong supplier relationships result in benefits beyond cost reductions. They can stimulate innovations, reduce risks, and provide opportunities for further collaboration. Improved vendor relationship management with clear communication and fair treatment can incentivize suppliers to offer better deals, services, or exclusive products.

  • Eco-friendly procurement methods: Providing a solution to the rising global concern about sustainability and using eco-friendly procurement methods can be cost-effective. For example, frequently sourcing renewable materials or recycled goods proves less expensive and projects a socially responsible image, which can attract more customers in the long haul.

Streamline the production process and minimize costs

Streamlining your production process and minimizing costs might seem daunting, but with the right tools, it's entirely achievable. GelatoConnect can be your ally in this mission. Its automated procurement system, real-time reporting, and centralized data management solutions help maintain optimal inventory, reduce procurement costs, and avoid unnecessary expenses.

With GelatoConnect, you won't just survive - you'll thrive in an ever-changing business landscape. Don't wait for tomorrow. 

Sign up for GelatoConnect today and take the first step toward cost-effective and efficient operations.

Cost of raw materials FAQs

How can businesses effectively forecast the cost of raw materials?

Effective forecasting involves analyzing historical price data, market trends, and supplier insights. Businesses can use statistical tools and software to predict future price movements and assess potential impacts on material costs and manufacturing overhead. Staying informed about global economic indicators, such as commodity prices and exchange rates, also helps in making more accurate predictions.

What strategies can be employed to hedge against price volatility in raw materials?

To hedge against price volatility, businesses can engage in futures contracts, options, and forward contracts, which allow them to lock in prices at a predetermined rate. Another approach is strategic stockpiling of raw materials when prices are lower. Additionally, forming long-term partnerships with suppliers can lead to more stable pricing agreements.

Can lean manufacturing principles help in reducing the cost of raw materials?

Yes, lean manufacturing principles can significantly reduce material costs by optimizing the use of resources and minimizing waste. Techniques such as just-in-time inventory (reducing material holding costs), kaizen (continuous improvement), and value stream mapping (identifying and eliminating non-value-added activities) are particularly effective. These methods not only lower the costs of raw materials but also enhance overall operational efficiency.


Next steps

Learn how GelatoConnect can grow your business