There are a variety of ways to measure the value of your inventory. If you’re a business owner, you might look at different tactics to see what work best for you. This may include the last-in-first-out method, the first-in-first-out method or the weighted average method. Unleashed Software uses the weighted cost method. There are pluses and minuses to each system. Let’s delve a little deeper into the weighted average method and see why it’s useful for valuing inventory.
What is the weighted average method?
Basically, the weighted average method takes into account all costs experienced by the business to obtain the inventory stock and distributes it across all units. So, what’s included in the costs? The inventory costs account for the initial inventory value, as well as any purchases made during the accounting period. The units represent the initial inventory stock count and the number of units bought during the accounting period. It’s the accountant’s job to add up the total costs alongside the total units. When both have been tallied, an accountant will divide the total costs by the total units. Effectively, this will yield the average unit cost.
Real-world application of the weighted average method
Let’s break this down with an example. Perhaps your company sells hammocks. Your beginning inventory is 500 hammocks, with a value of $5.00/unit, totalling $2,500. You make several purchases to top up your inventory stock throughout the month. Have a look at the following purchases below:
- 750 hammocks at $7.00 per unit = $5,250
- 400 hammocks at $4.00 per unit = $1,600
- 300 hammocks at $6.00 per unit = $1,800
Then, you add up all of the hammocks (500 + 750 + 400 + 300) = 1950 hammocks. Next tally up your costs, ($2,500 + $5,250 + $1,600 + $1,800) = $11,150. To determine the cost per hammock for all hammocks available to be sold take $11,150/1950 = $5.72/hammock.
The pluses of the weighted average method
With this method, a company is able to value their inventory stock consistently. By keeping the product cost the same, it allows for a consistent measure across the board. Once the product cost is determined by the accountant, it can be translated across all units. This standardises the process to incorporate the price used for ending inventory value and cost of goods sold. This is much more straightforward and simplifies a process to provide consistent answers.
This simplification also translates into decreased paperwork for the business. Since the calculation is standardised, there are only a few calculations that an accountant needs to do so they can achieve the answers. In this method, detailed account records become redundant. It’s more important to keep track of the overarching totals, rather than each purchase record.
Essentially, the calculation is only three steps. In comparison to other methods, this is a very basic but effective calculation that yields important numbers to guide decisions.
The minuses of the weighted average method
If you’re using a periodic inventory system, you’ll only update your inventory and cost of goods at the end of each period instead of every time you make a sale. This means that you might only look at your inventory and the cost of goods sold once a month. This will not keep you informed of your business’ health so that you can actively correct it.
However, Unleashed uses a perpetual inventory system so that each stock movement is recorded instantly. When you make a sale, Unleashed will deduct stock from your inventory and instantly push this transaction through to your chosen accounting software. This will automatically adjust the weighted average cost of your stock so that you can keep on top of your margins as it happens.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. When not writing about inventory management, you can find her eating her way through Auckland.