The weighted average cost method is an accounting approach to inventory valuation, it is used to determine the cost of goods sold (COGS) and the ending inventory stock.
Weighted average accounting assumes that all units are valued at a weighted average cost per unit, and it applies this calculated average to the COGS in addition to the units held in ending inventory.
The calculations used in the average cost method depend on whether the business is using a periodic or a perpetual inventory system.
- Periodic inventory as an inventory valuation method relies on a physical inventory count undertaken at set times. In the periodic inventory system, the COGS is not ascertained until the end of the accounting period.
- The perpetual system continuously updates inventory whenever a purchase is made from suppliers or a product is sold to a customer. Any time an item has been returned due to damage or defect or where cash discounts have been applied, an adjustment is made.
Periodic weighted average cost method
Under a periodic inventory system, the average cost method calculations are carried out at the end of the accounting period, with the weighted average cost based on the cost of the beginning inventory plus all purchases made during that period. This average cost per unit is then applied to the units sold and the units held in inventory.
Using the average cost method, the total cost of goods available for sale is averaged and any two units are sold at the average cost.
A business using the periodic inventory accounting system can ignore the fact that a sale can occur at the beginning of a month before final purchases at the end of that same month. Beginning inventory and purchases are simply combined to calculate the weighted average unit cost using the average cost formula.
Perpetual weighted average cost
In contrast to the periodic method, the perpetual inventory system records transactions continuously and average cost method calculations are carried out during the accounting period whenever a purchase or sale takes place.
The weighted average cost per unit is based on the cost of the beginning inventory and the purchases up to the point at which a sale takes place. This process is sometimes referred to as the moving average cost method.
In the weighted average perpetual inventory system, purchases and sales are dealt with in chronological order and a weighted average unit cost calculation is needed every time a sale is made. Because the weighted average is continually calculated, the perpetual inventory average cost method is sometimes referred to as the moving average cost method.
The implications of the weighted average cost method
Implications of using the weighted average cost method for inventory are that when prices rise, COGS are less than that acquired under the Last in First Out (LIFO) method, but more than that acquired under First in Last Out (FIFO). When comparing the two alternatives, inventory stock is not as badly understated as under LIFO, but it is not as current under FIFO. Weighted-average costing, on the other hand, takes a middle-of-the-road approach.
Businesses can bias reported income under the average cost method by buying or not buying inventory stock near the end of the financial year. Conversely, the averaging process reduces the effects of whether a company buys or does not buy stock.
The various inventory costing methods involve assumptions about how costs flow through a business. In some cases, assumed cost flows may agree with the actual physical flow of stock. Although physical flows can be declared in support for a specific inventory method, it is recognised that an inventory method’s assumed cost flows don’t necessarily correspond with the actual physical flow of the goods.
What is agreed, is that the inventory valuation approach you use will impact directly on the profit, tax and closing inventory of your company!
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.