Weighted Average Cost Method

Is an accounting formula used to calculate the inventory value

Any business that sells physical products is going to need a way to deal with inventory efficiently. Generally, inventory deals with any goods to be sold, whether they were purchased directly from the manufacturer or produced in-house.

Weighted Average Cost Method

One of the most effective methods that are commonly used by businesses is the weighted average cost method (WAC).

WAC is an accounting formula used to calculate the inventory value. It is also one of the simplest methods and can be used whether the goods are produced in-house or purchased by the company.

The WAC method is a method used in accounting to determine the amount that goes into the cost of goods sold (COGS) and inventory by using a weighted average.

You get WAC by dividing the cost of goods available for sale by the number of units available for sale.

WAC is usually used to assign the average cost of production to a good and is most commonly used when inventory items are intermingled to the point where it becomes difficult to assign a specific cost to an individual unit.

WAC may also be used when the accounting system in place is not sufficiently sophisticated to track FIFO (First-in, first-out) or LIFO (Last-in, first-out) inventory valuations or when the inventory items are extremely commoditized to the point where there is no way to assign a cost to an individual unit.

Warehouse

The value of the weighted average cost method gives a picture of the cost somewhere between the oldest and newest units purchased into inventory. Likewise, the COGS will display a cost somewhere in the middle of the oldest and newest units that were sold during the period.

The method has an assumption that a company sells all of its inventories simultaneously. Knowing this figure helps businesses make better buying decisions.

Both GAAP and IFRS accept the weighted average cost method as an acceptable approach to an inventory valuation method.

Laptop and graphs

How to calculate the weighted average cost?

The WAC method has simplified accounting for businesses. The formula for calculating weighted average cost consists of two different parts:

  • Costs of goods available for sale:

Costs of goods available for sale is calculated by the following formula:

Beginning Inventory Value + Cost of Goods Purchased = Costs of Goods Available for Sale

In order to find this figure, you'll need to keep track of the total amount of beginning inventory and recent purchases.

  • Units Available for sale:

Units Available for sale is a metric that is composed of the number of units a business can sell or the total number of units in inventory + purchases in units.

The WAC per unit formula looks like this:

WAC Per Unit = Cost of Goods Available / Units Available for Sale

WAC per unit is a metric that can be used to assign a cost to both the COGS and ending inventory. The final calculation will give you a weighted average value for every item available for sale.

Your WAC will vary depending on which of the two inventory systems you use (see below). 

WAC provides many benefits, such as:

  • Easy to understand the value of your inventory 
  • You don't have to be as precise about which items in the inventory were bought at what specific time and how much they cost, leading to less record keeping.
  • Less record keeping leads to more time for other business operations. More time spent on these other operations can lead to more money earned for the business.

Equations

Understanding the Cost of Goods Available for Sale

The cost of goods available for sale is the cost of raw materials and labor that are put into the production and manufacturing processes of goods that a company has that are finished and ready and available to be sold.

Another way to understand this concept is that the cost of goods available for sale is the total cost of the inventory that is available for consumers to buy at the beginning of an accounting period.

Remember, to get the cost of goods available for sale; you add the cost of goods purchased to the beginning inventory (see formula above).

The COGS is a metric for companies to use when trying to determine a company's gross profit. The figure can help the business prepare for a specific amount of profit, influencing and motivating many business decisions.

For example, if a business expects to make $250,000 in profit this year, the business may elect to hire more employees or expand the workspace by moving office buildings.

When you allocate the cost of goods available, it is called a cost flow assumption.

There are three commonly used cost flow assumptions in accounting:

  • FIFO (First-in, first-out)
  • LIFO (Last-in, first-out)
  • WAC Method (Weighted Average Cost Method)

Notes

Weighted Cost Average vs. FIFO vs. LIFO

The cost of development for products must be recognized on financial statements. Businesses aren't allowed to immediately deduct the full cost of inventory purchases against their taxable income. The solution is that the cost of inventories is deducted when sold.

The question is, when do they deduct the inventory purchases?

This depends on what inventory valuation method a company uses.

FIFO is an accounting method used for inventory valuation that says assets acquired or purchased first are disposed of first. The purpose of FIFO is for cash flow assumption.

For FIFO, the oldest (or first) cost of an item in the inventory of a business will be removed first when one of those items is sold. The oldest item will then be recognized on the income statement under the COGS figure.

FIFO helps a company sell inventory before it becomes obsolete.

LIFO, is another accounting method for inventory valuation used for recognizing the most recently produced items to be first expensed on the income statement.

Using LIFO usually results in a lower net income but can be tax advantageous.

While LIFO is allowed under GAAP, it is not an allowable method under the IFRS.

Typically, LIFO is a method that is used by larger companies with more inventory and can take advantage of higher cash flows and lower taxes.

For example, many auto dealerships rely on the LIFO accounting method for their inventory valuation so they can defer taxes. Since businesses can include inflation in the COGS using this method, it's a good way to reduce tax liability temporarily.

FIFO is usually the preferred method in times of rising prices because it allows for costs to be reported as low and reported income will be high. LIFO is usually the preferred method when tax rates are high because the reported cost will appear high, and income will be low.

Papers

Example of WAC vs. FIFO vs. LIFO

Suppose you are the owner of a shoe store, and you buy 100 pairs of shoes for $30 per shoe. The next month, you purchase another 200 pairs of shoes at this time for $40 each. At the end of the year (your accounting period), you managed to sell 50 shoes in total.

  • 100 pairs of shoes at $30 each = $3,000. 200 pairs of shoes at $40 each = $8,000.
  • The total number of shoes = 300 pairs.

First in, first out (FIFO) cost:

  • Cost of goods sold = 50 * $30 = $1,500.
  • Remaining inventory cost = (50 * $30) + (200 * $40) = $10,500

Last in, first out (LIFO) cost:

  • Cost of goods sold = 50 * $40 = $2,000.
  • Remaining inventory cost = (100 * $30) + ($150 * $40) = $9,000.

Weighted Average Cost Method:

  • Cost of a shoe = $11,000 / 300 = $36.67 per shoe
  • Cost of goods sold = $36.67 * 50 = $1,833.33
  • Remaining inventory cost = $36.67 * 250 = $9166.67

The WAC method under periodic and perpetual inventory systems

Using different inventory systems will yield different allocations of inventory costs. The two inventory systems used are periodic and perpetual.

A periodic inventory system is when a business does an ending count. These companies apply product costs to calculate the ending inventory cost. The business can then calculate COGS by adding together the ending inventory cost, the beginning inventory cost, and purchases that were made in between.

Calculating WAC when using a periodic inventory system is probably the easiest out of the different inventory systems. It's pretty simple. The calculation is done at the end of the cycle, so all you have to do is figure out the total cost of goods available for sale and divide it by the number of units.

When using a periodic inventory system, it may be helpful to separate purchases from sales.

On the other hand, calculating WAC when using a perpetual inventory system is probably the hardest method. Since you have to calculate a new weighted average cost for each sale based on the units available at that time, it can get really complex and time-consuming.

A perpetual inventory system is when a business keeps a continuous track of COGS and inventories. This method can be extremely costly for a company, but it does have its benefits.

It allows businesses to have a better understanding of their inventory and provides information for managing the inventory levels in a more timely manner.

Make sure, when using a perpetual inventory system, to not separate the purchases and sales.

Work

Example:

Suppose you're a business owner and you sell baseball bats. It is now the start of a new fiscal year, so you purchase 200 baseball bats for $35 each ($7,000). Throughout the first quarter, the business makes the following purchases:

  • On January 21st, the company bought 100 more baseball bats at $45 each ($4,500).
  • On February 15th, the company bought 50 more bats at $50 each ($2,500).
  • On March 2nd, the company bought 175 more bats for a price of $75 each ($13,125).

Throughout these first few months, your business made the following sales:

  • At the end of February, the company sold 75 baseball bats
  • At the end of March, the company sold 50 baseball bats

Next, we will use the periodic inventory system to calculate the WAC.

When using the periodic inventory system, we must calculate the cost of goods available for sale and the baseball bats available for sale at the end of the first quarter:

WAC per baseball bat = (7,000 + 4,500 + 2,500 + 13,125) / (525) = $51.667

Using this method, we can see that over the first quarter of sales of 125 baseball bats, we would allocate $51.667 per baseball bat sold. The excess would go into ending inventory.

This would look like this:

  • 125 * $51.667 = $6,458.38 in Cost of Goods Sold
  • $27,125 - $6,458 = $20,666.63 in ending inventory

Numbers

Now we will calculate the WAC using the perpetual inventory system:

When using a perpetual inventory system, you will calculate the average before the sale of units

So, we would calculate the average before our first sales in February, and it would look like this:

WAC per baseball bat = ($7,000 + $4,500 + $2,500) / (350) = $40

For the sale of 75 baseball bats in February, the costs would be allocated as shown below:

  • 75 * $40 = $3,000 in Cost of Goods Sold
  • $14,000 - $3,000 = $11,000 remaining in inventory

Then we need to calculate our average before the sales of March:

WAC per baseball bat = ($11,000 + $13,125) / 450 = $53.61

For the sale of 50 baseball bats in March, the costs would be allocated as shown below:

  • 50 * $53.61 = $2,680.56 in Cost of Goods Sold
  • $24,124 - $2,680.56 = $21,444.44 in ending inventory

Calculations

Comparing WAC methods under the periodic and perpetual inventory systems

So, as we see from the two different methods above, the type of inventory system you choose will affect your figures. The two figures affected above are the cost allocated to COGS and ending inventory.

Despite these differences in the amount allocated to COGS and ending inventory, the total cost remains the same for both inventory systems.

We can see that in our example, the costs per baseball bat rose every month. In January, it cost $45 per bat, then $50 in February, and lastly $75 in March. This is a phenomenon called price appreciation.

Price appreciation is the increase in the price or value of a good or service over a period of time. This is the opposite of depreciation, which is more common throughout global economies.

Because the periodic system uses the whole quarterly figure of costs of goods available for sale, more money ends up being allocated to COGS than in the perpetual system.

 On the other hand, this means that the amount in ending inventory is greater for a perpetual inventory system.

Analysis

So which system is better?

The perpetual inventory system is generally more effective than the periodic inventory system. This is the case due to improving technology. The computer software that most of these businesses use makes the process simple and hands-free.

All products in inventory have barcodes and are able to be tracked all the way to sale through point-of-sale technology. Through this technology, companies are now able to see all the information they need about products and more.

Perpetual inventory systems are able to keep a more accurate account of records about COGS and the cost of goods purchased.

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