Pile of Wool
Although they can be bought from NPC Tailor Vendors, it is much less expensive to collect them by hand. Use a bladed item on a live sheep to shear it and place the wool directly into your pack. Shorn sheep will eventually regrow their wool.
A Pile of Wool can also be obtained from a dead sheep that wasn't shorn before death. This Pile of Wool will not stack with the other, cannot be sold to an NPC, and will only produce one Balls of Yarn each. Some say it is a slightly different hue, but that seems to be up for debate.