Accounting cost methods are used to control how a businesses inventory expenses appear on the company books. The weighted average is an accounting cost method used to value a company’s inventory by applying the average cost of on-hand inventory to each item of inventory stock. This means that both the cost of goods sold (COGS) and on-hand inventory are treated comparatively the same when it comes to determining value.
Average costing, however, isn’t always the best accounting cost method or the right approach for all businesses or industries because it can have ramifications for accounting and tax reports. For example, if there are clear upward or downward swings in inventory costs, average costing may understate or overstate the COGS, and consequently, the businesses declares a profit.
One of the main reasons companies choose weighted average costing over other costing methods is because it radically simplifies cost calculations and record keeping. SMEs may utilise the weighted average method for its simplicity or because they lack the knowledge or the right inventory management tools to track FIFO or LIFO inventory layers. So how do you know if the weighted average costing method is right for your business?
When to use weighted average costing
The weighted average method works well if you are purchasing inventory stock on a regular basis. When your inventory has a relatively fast turnover, there is generally very little difference between average costing and an alternative LIFO costing method. Even with a high reorder frequency, average costing is easily processed because you aren’t tracking every purchase or its respective price and volume.
This method is commonly used when inventory items are so blended or identical to each other it is impossible to assign specific costs to individual units. Many manufacturing businesses rely on weighted average costing because inventory is often stockpiled or combined making it difficult to differentiate between older and newer materials.
For instance, in coffee roasting, one batch of coffee beans may be mixed with another batch of the same beans. The difficulty in accounting for the separate coffee beans suggests the company would use a weighted average cost approach. Equally, if the day-to-day costs of raw ingredients are unpredictable, change often yet remain within a stable range, using average costing will smooth inventory costs over time.
It is worthwhile to note however that work-in-process figures are not kept separate in the average costing method, they are instead combined with material costs and then averaged out. This can cause confusion, increase the risk of human error and makes it difficult to effectively track work-in-process for company records.
Industries suited to weighted average costing
Manufacturing is not the only industry suited to average costing. In the agricultural sector weighted average costing is often used because produce such as fruit, vegetables and grain or any other product grown in pastures and mass harvested, cannot be accounted for individually. Likewise, some animal products are also collected in large quantities making it difficult to differentiate them on an individual basis. For these types of products, weighted average costing makes it simpler to allocate costs.
The manufacture of chemicals or the extraction, collection and storage of liquid fuels and related products makes it necessary for chemical, gas and petroleum industries to utilise weighted average costing. The method would be applied in both the manufacture and sale of these products because there is no capacity to separate batches of chemicals or fuel from each other when they are stored together.
When is average costing not the best approach?
For retailers or manufacturers that purchase in bulk and when there are significant time lapses between purchases, using average costing will produce substantially different results from other costing methods. If batch units are not identical, and/or there are significant price variances between each batch, they cannot be treated in an identical manner for costing purposes. In this instance, you would achieve greater accuracy in tracking costs on a per-unit basis.
Alternative costing methods provide a more detailed level of costing for each individual cost element. If you need to track overhead costs LIFO and FIFO, unlike average costing, allocates a more accurate inventory cost to those products that actually incur the costs.
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.