A guide to how the weighted average cost method works and why it may or may not work for your business.
The Stormlight Archive and Atlas shrugged. are two of the longest books I have read. They come in at over a thousand pages and over 55 hours of listening time if you, like me, choose the audiobook route.
Sometimes it feels like reading through all the ways you can account for inventory would take just as much time. Should you use FIFO or LIFO? Should you use periodic or perpetual?
Today we’re looking at another option: the weighted average cost method. Read on to learn how this method differs from the FIFO and LIFO methods and the pros and cons of using it in your business.
Presentation: what is the weighted average cost?
Most businesses with a periodic inventory system use the first-in, first-out (FIFO) or last-in, first-out (LIFO) methods to calculate inventory. These methods associate a price with each unit of inventory and then calculate the cost of goods sold (COGS) based on the units sold.
This approach is not feasible for everyone. If you are selling homogeneous inventory that is constantly replenished, it may be impossible to track which unit was purchased and at what price.
Weighted average inventory solves this problem. Instead of trying to tie a price to each unit, the method uses a weighted cost that averages the price of all inventory that has been purchased. This simplifies things at the end of the period, when the inventory numbers are finalized.
Weighted Average vs FIFO vs LIFO: What’s the Difference?
Let’s see how the cost of goods sold and ending inventory would be calculated using the three methods.
In this example, there is an opening inventory balance, three purchases of different unit quantities, and then a sale of 250 units. To calculate the cost of goods sold, we must either choose the 250 units sold or establish an average price to apply to the units sold.
Using FIFO, the 120 units of the initial stock, 80 purchased on June 1, and 50 of the units purchased on June 5 were included in the COGS calculation.
LIFO uses all units purchased in June and 30 units from the initial inventory.
Weighted average cost takes the average of each purchase, weighted by the number of units purchased, and applies it to the number of units sold. We’ll see how to calculate the weighted average for this example in the next section.
There is not much difference in COGS between the three methods due to the small numbers used in the example. However, companies that rotate inventory quickly or have larger price jumps than in this example may see that difference quickly add up to a larger change in the income statement.
The difference between LIFO and FIFO is in the units used to calculate the cost of goods sold. The weighted average uses an average of all units in stock.
How to Calculate Weighted Average Cost
Here’s how we calculated the weighted average cost in the example above:
When the sale is made on June 10, there are 340 units of inventory. We start by finding the percentage of total inventory that each transaction represents by dividing the number of units it contains by the total of 340.
Then, multiply that percentage by the price of each trade to find the adjusted price. Finally, add the adjusted prices to get the weighted average cost of $12.08 and multiply it by the number of units sold to find the cost of goods sold of $3,019.85.
New starting stock is 90 units (340 units total – 250 units sold) with an average price of $12.08, totaling $1,087.15. You can also calculate this by subtracting the cost of goods sold from the total inventory cost before the sale (340 units x average price of $12.08).
It is good practice to count inventory at the end of each period and compare it with the calculated ending inventory to find any shrinkage. Shrinkage is the loss of inventory due to damage, loss, or theft.
Advantages and Disadvantages of Using the Weighted Average Cost Method in Your Small Business
Is the weighted average cost right for your business? Here are some pros and cons of the system.
Advantages of the weighted average cost method
Here are some advantages of using blended cost:
- You don’t have to link prices to units: The most time-consuming part of the LIFO and FIFO methods is tracking each batch that arrives with its price to ensure that the items are sold in the correct order. With the weighted average cost method, when inventory comes in, you simply record the purchase and update the current weighted average cost.
- You may be able to pay less for accounting software: While we certainly wouldn’t recommend skimping on accounting software, if you’re just starting out and don’t even have a second employee, the weighted average cost method would make it easier to track inventory on a spreadsheet – or even in hand.
- You have a consistent price: With FIFO and LIFO, profits are based on the oldest or most recent purchases. If there has been a significant price change, the calculated COGS and Gross Margin will not be accurate and could lead to wrong decisions. If you have a weighted average cost in mind when pricing and purchasing, it will lead to better decisions.
Disadvantages of the weighted average cost method
Here are some disadvantages:
- Your inventory may be too heterogeneous: Over time, products change. They evolve through added features and removed bugs. This development is accompanied by logical price changes. If your inventory is running slow enough, you might have three or four iterations of the same product in an amorphous blob of “product x” in the inventory count. It’s fine to sell different versions of products, but be aware of significant product changes and, if they occur, split new inventory when registered.
- You can include wrong prices: Although constant pricing is an advantage of this method, if your business has a concentration of inventory at an earlier date when prices were much lower, it will reduce the cost of your inventory. The declared profit will be correct, but the margin could lead to bad decisions if you assume that it will remain so high forever. Unfortunately, this problem cannot be solved by using a different method, such as FIFO, because the same inventory cost would be used. It’s just another situation to consider – you need to report the cost of goods sold using obsolete inventory, but that doesn’t mean you have to make decisions based on that profit figure.
- You can of course use FIFO to sell stocks: If your products are perishable or degrade over time, chances are you follow a first-in, first-out policy when selling the items. The faster you sell old items, the less likely they are to get lost. If you are in this situation, go ahead and use FIFO so you can keep your accounts as close to real business practices as possible.
Should we switch to weighted average cost?
While it’s a good idea to do extensive research before making major business decisions, it probably won’t take 55 hours of reading to figure out the best inventory accounting method for your business. It should be intuitive.
If you sell perishables or a lot of different things, use FIFO. If you sell the same product multiple times, use the weighted average cost. If you like having a migraine, use LIFO.