Moving Average Cost: How to Calculate Moving Average Cost
Does your company sell goods or offer services to consumers? Well, as an experienced entrepreneur, maybe you appreciate how a healthy inventory is crucial for the former in meeting the clients’ needs.
On the other hand, we’ve got to understand that several small and medium-size enterprises find it quite difficult calculating the monetary value of their inventories at times.
Applying various principles and computations in accounting can help keep a good track of both the items sold and those remaining in stock irrespective of the size of the company.
One of the commonly used accounting principles for the purpose of maintaining a healthy inventory is average cost which entails numerous methods including moving average cost, which is our focus today.
A simple yet effective method!
First, let’s define moving average cost before looking at how it is calculated and its significance in detail.
What is Moving Average Unit Cost (MAUC)?
MAUC or simply moving average cost is an inventory valuation method in which the average unit cost of a good is newly computed following every acquisition of the items in question.
Basically, you do this by adding the cost of the freshly-purchased items to the cost of the similar commodities previously present in the inventory. Then you divide the sum by the current total number of goods.
Without disruptions, you are bound to continuously sell the items and replenish the stock throughout the year, therefore, calculating the moving average is a perpetual undertaking.
Seems simple, right?
Well, there’s more to the adding and dividing.
Grab your pen, grab a piece of paper, a calculator (maybe), and ready, set, go!
How to Calculate Moving Average
There are four main ways of calculating moving average. Each method gives a different result. The method to apply depends on your objective and the type of dataset.
They are as explained below:
1. Simple Moving Average
Just from its name, SMA is the simplest method of calculating Moving Averages. It helps to identify if a security or index has a downtrend or an uptrend. Another common, albeit somewhat more complex, use of SM is comparing other moving averages.
It is also known as the arithmetical moving average. Here, you’ll first sum up the various prices of the instrument closure (should be done over the total number of periods, let’s say 12 hours). Then, the resulting value from the addition is divided by the total number of the periods.
The formulae of the calculation are:
SMA = Sum (PRICECLOSE), Nv) / Nv
Nv — total number of the calculation periods.
PRICE CLOSE — close price of the current period close price;
Sum — Sum of various prices
2. Exponential Moving Average
Calculating the moving average cost by EMA is somewhat different from SMA. SMA has an undesirable property which treats the k observations similarly. This property also assumes all the preceding observations thus making SMA “unreliable”.
Intuitively, the past data ought to be discounted gradually and smoothly. For instance, you should ensure that your 1st current observation is weightier than the 2nd most current. On the same note, your 2nd most current observation should be weightier than the 3rd most current, and the flow continues.
While SMA fails to accomplish this flow, EMA achieves it.
In EMA, you’ll sum up a specific share of the closing price to your preceding moving average value. You’ll realize that the exponential moving averages have more current close prices than the simple moving averages. Generally, the P% EMV looks as below:
EMA = (PRICECLOSE * Pv) + (EMA (i – 1) * (1 – Pv))
Pv — the % obtained by using a price value.
PRICE CLOSE — the close price of the current period
EMA (i – 1) — Moving Average value of the preceding period
3. Linear Weighted Moving Average
In LWMA, the latest data is regarded to be more valuable than the earlier data. To calculate your LWMA, multiply your closing prices by a weight coefficient. i.e.:
LWMA = SUM (PRICECLOSE * i, Nv) / SUM (i, Nv)
PRICECLOSE — the most recent close price;
Nv — the smoothing period
SUM (i, Nv) — total sum of weight coefficients
SUM — sum
You’ll understand more with the following example:
A security firm had the below closing prices over a 15-day period.
Week one (five days): 21, 23, 25, 26, 24
Week two (five days): 27, 29, 27, 29, 28
Week three (five days): 29, 31, 28, 30, 29
When calculating a ten-day MA using the simple moving average cost method, average the firm’s closing prices recorded in the 1st 10 days (this will be your 1st data point.) Note that, while doing so, the preceding data point will drop your earliest price and add the next price recorded on the 11th day. Once this is done, the average will be successfully calculated.
What is the Significance of Moving Average Cost to Your business?
The joy of any business owner is making profit which is dependent on how fast the goods at hand are sold and restocked.
But every item sold must be accounted for; in order for the company to remain afloat. Hence, you must keep an updated inventory. This may be simple and straightforward when dealing with products that can be counted individually.
However, for items that are sold in bulk including grains, liquids, nuts and many others, it becomes cumbersome keeping track of the quantity of those sold and the ones remaining in stock.
Here is where the moving average cost method comes in handy!
To illustrate the practical importance of MAC, we’ll look at a simpler example:
Assuming you sell petrol with 40 gallons in stock, you make a new order and a delivery of 250 gallons is made; though at a different price. Selling the two sets of petrol separately will be impossible since they will be mixed in one tank. Nonetheless, the fuel must be sold without making losses.
Computing a new selling price is therefore integral in ensuring the customers’ needs are satisfactorily met and the business also makes profit. This will require you to employ the moving average inventory valuation method.
With every fresh purchase, the moving average must be updated and the process is even eased by certain software developed to assist in the calculation.
MAC is essential in helping you keep the company’s financial status in check as it is applied in recording the inventory and even computing asset net worth.
Again, in gross profit calculation, moving average unit cost is primary as it is used to compute net sales plus the total cost of items sold.
Are you looking for a way of determining the most current selling price for your business? Moving average cost is the most reliable method despite how complicated it may seem!
Where Should I Apply the Moving Average Cost Method?
Various accounting techniques are applied depending on the structure of the business.
For instance, a perpetual inventory system allows you to use moving average as the inventory items are readily updated after acquisition.
In contrast, the periodic inventory tracking system accumulates stock information at the end of an accounting period without maintaining the individual unit records. This implies that it is not compatible with moving average which changes with every new order.
Assumptions Made When Calculating Moving Average
Noteworthy, the method makes different assumptions. The basic assumptions made include:
- The units of similar product categories carry the same costs and may not be suitable for your enterprise if the units of the same item are of varying costs.
- The time series applied is stationary and has a varying mean. Therefore, moving average will help in estimating the mean’s current value and the results used as forecasts of what will happen in the estimated future. With this assumption, a compromise is made between the random-walk-drift-model and the mean model.
- By modifying the moving average width (which is the smoothing degree), you’ll strike a healthy balance between the random walks and the mean.
How do I Track My Moving Average Unit Costs?
It is essential that a company tracks the moving average costs to ensure the customers’ needs are served better.
As a business operator, you can do this on a spreadsheet and update the values manually whenever you receive purchase orders.
You can also save time and avoid the numerous errors prone to occur with the manual method by automating this process using macros in the spreadsheets or one of the computerized programs for the same.
Once the moving average cost is calculated, the ending inventory costs plus that of sold goods are set that specific average cost. During the computation, you should be keen to include landed costs in the general price of purchased items.
Does the Moving Average Cost Method have Any Drawbacks?
The moving average cost method also has some few drawbacks. Some of them include:
Not suitable for Sideways Market
The moving average cost method creates many whipsawed signals which can be so costly to investors. They don’t work well during sideways or non-trending markets. Rather, they’re more suitable for trending markets. And as we may all know, most markets can only trend for a short time, thus the practicality of the MA costs is slender.
Mispricing of non-similar product sets
The moving average cost method makes the assumption that all item units are
similar. But this may not be true in the case of goods that can be improved in
one way or another. For example, if the product has recently been upgraded, it
should attract a better price than the previous units but this won’t be taken
into account by the method.
The MAC method utilizes past purchasing records to determine what you have
been paying per unit making it difficult to pick out the cases of underpricing of
goods until a financial year elapses.
Another issue that may arise if the inventory prices have a great disparity making it impossible to recover the cost of units which are more exclusive. This
could lead to losses with the set selling prices.
Is the Moving Average Calculation Worth it?
Nothing in accounting can be as simple yet accurate and potent in valuing your business inventory as moving average cost.
With this tool, your products will always be sold at the most current price ensuring that you best serve the demands of your clients.
Small-size enterprises can easily track their MACs manually via spreadsheets or on paper but with growth, the work may become overwhelming.
It is therefore recommended that you automate this process using reliable software packages which perform the dirty job while allowing you to optimize other aspects of your business.
However, from the assumptions, it is not recommendable to use the moving averages cost method as the only trading system. Rather, every business owner should consider pairing it up with various oscillators and indicators that will make it more applicable in the current market.
Did You Know?
- Businesses can have negative stock and, in such instances, the MAC calculation method won’t account for this existing negative stock whenever it is re-evaluated.
- The cost/unit will change when there is a purchase. However, this cost remains the same after an inventory sale. The two affect the moving average cost calculations.
- If a firm deals with selling stock, it will have to recalculate the MAC after making every transaction.
- When calculating the MAC, be sure to capture and factor in the landed into the cost of the goods purchased.
- Also, deriving inventory valuations by the help of a computer system makes it pretty easy to adjust the inventory valuations using the moving average cost calculations. Conversely, using the MA method becomes difficult if the inventory records are only maintained manually.
The preferred type and number of moving averages cost methods vary considerably from one trader to another. The variation is mostly dependent on the underlying index or security and the investment strategies that an organization applies.
Noteworthy, EMAs are commonly used by firms because they lag less and give more detail on the recent prices. The popular MA ribbon examples include 8 separate Exponential Moving Average lines, differing in length.
Now, you can up your game!