The weighted average cost method is an accounting method that businesses use to value inventory. This method of valuing inventory involves proportional treatment of both the cost of goods sold (COGS) and the inventory item in stock at the time of valuation. This means that both are treated the same when it comes to determining value.
The primary benefit to the weighted average cost method is that it levels out price fluctuations. As with all cost accounting methods, the weighted average cost method has advantages and disadvantages that directly relate to the characteristics of inventory stock and the purpose of valuation. This, in turn, will provide an understanding of when your business should use the weighted average cost method and determine its appropriateness.
Advantages of the weighted average cost method
Your business can benefit more from this method in the following circumstances:
- When individual units of SKUs are relatively indistinguishable from each other
- Where tracking the cost associated with individual units is difficult
- When the cost of raw materials may fluctuate, but remain within a specific range
- If purchasing materials on a regular basis
The simplicity of using the weighted average cost method makes it easier to work with as it is fairly minimalistic and self-guided. This tends to yield more accurate cost computations, which would otherwise require considerable staff time to track on an individual basis.
Another main benefit is that the weighted average cost method will mimic reality closer for the COGS, and may mitigate the tax impact.
Disadvantages of the weighted average cost method
Your business may have less benefits using this method in the following circumstances:
- Where units in a batch are not identical and expensive, they cannot be treated in an identical manner for costing purposes. Tracking costs on a per-unit basis would be more appropriate
- Large and infrequent bulk purchasers using weighted average costing may experience significantly different valuations from other costing methods due to a major disparity in price that could arise
- In the weighted average cost method, the work-in-progress figures are not generally kept separately. Instead, they are pooled with material costs and then divided out. This can create confusion and could make it more difficult to track work-in-progress effectively for business records
Typically, a standard costing method allows a business to maintain a more detailed level when costing for individual cost elements. For example, if you need to track overhead costs, standard costing methods allow you to re-value on-hand inventory, not a limitation experienced using weighted average costing methods.
Industries that use weighted average cost method
In this industry, inventory is usually stockpiled or combined so that it is difficult to differentiate between older and newer goods. For instance, in chemical manufacturing, one batch of a chemical may be mixed with another batch of the same chemical. A manufacturer uses a weighted average to accurately record cost valuations in these difficult circumstances.
Product grown in a field and mass harvested, such as grain cannot be accounted for individually. Likewise, some animal products are collected in large quantities and are not differentiated on an individual basis. Using weighted average cost methods provides a simpler way to account for these types of items.
The extraction, collection and storage of liquid fuels and related products make it necessary for manufacturers and sellers of these products to use this method. The inability to differentiate one batch of fuel from another when they are stored together makes weighted average costing the suitable solution for keeping track of inventory valuations.
Your ideal inventory costing method may vary based on what you are valuing the inventory for. Consider the industry or sector your business is in, the type of inventory and your business’ circumstances will guide your appropriate inventory costing method.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.