What is the Weighted Average Cost Method? [Explained]
For any company to operate optimally, it is important to have an accurate valuation of its inventory. Inventory valuation has the potential to impact numerous business aspects such as profit margins, total assets, pricing models, and working capital.
It’s hard to determine if you are going to attain your revenue goals without knowing the worth of your inventory. It’s even harder to make any crucial business decisions without knowing how much your inventory is worth.
When you choose the right inventory tracking method, you will not only be able to manage your inventory, but it will also be possible to predict potential profit.
One of the ways to value your inventory is by applying the Weighted Average Cost Method ( also known as “Inventory Weighted Average”), which is one of the four most common inventory valuation methods.
In this article, we’ll explore how to calculate WAC, when to use it, how it compares with other inventory tracking methods, and how it could be advantageous to your business.
When To Use The Weighted Average Cost (WAC) Method?
The WAC method is commonly used when there is a need to conduct an exhaustive physical count to determine the number of inventory items available. This helps a business keep a track of extremely identical items and as well as determine the average cost of production of specific products.
The WAC method is especially ideal for companies that have a high inventory with items that are almost identical in cost. For example, if you sell different kinds of cooking oil in the same size bottle, you may have several unique distinct SKUs, but the value of each item will be relatively the same.
When Not To Use The Weighted Average Cost Method?
The inventory average cost method is not suitable for businesses that purchase inventory in bulk and there are big-time lapses between purchases. Using the WAC method in such situations could result in inaccurate results especially where there are big price variances between each batch of inventory.
The WAC method is also unsuitable for businesses that deal with perishable goods. This is because, for these businesses, it is easier to sell the goods that came in first to ensure they don’t go bad. This also means that cost in these businesses is best determined for individual units.
How To Calculate WAC
The formula for calculating the inventory average cost is pretty simple. All you need to do is divide the total cost of goods purchased by the number of goods that are available for sale. To determine the cost of goods available for sale, you need to add the total amount of beginning inventory and any new purchases. The final value represents the weighted average value of every item available for sale.
While calculating WAC may seem rather complicated at first, it gets way easier once you have fully understood it. Below is an example to help you get the hang of it;-
Company A’s inventory books for April are as follows:
|April Transactions||Quantity||Unit Cost||Total Cost|
|Beginning Inventory (April 1)||300||$4.00||$1200|
|Ending Inventory ( April 30)||900||$3.14 (average)||$2825|
Weighted Average Unit Cost for Company A= $2825/900 = $3.14
The Cost of Available Goods for Company A as of April 30 is $2825. The total units available for sale are 900. To determine the weighted cost average for Company A, all we need to do is divide the total cost of goods available by the total units available.
Company A’s WAC is, therefore, $3.14.
WAC under Periodic And Perpetual Inventory Systems:
While calculating WAC, businesses may employ either the periodic inventory system or the perpetual inventory system. Both of these systems have different methods of allocating the cost of inventory.
Periodic inventory management refers to the intermittent counting of physical goods in determined intervals e.g monthly, weekly, etc. Conversely, perpetual inventory management refers to the constant updating of products as they move in and out, in real-time.
When it comes to inventory cost allocation, the two systems differ as follows;
- Periodic Inventory System: In this system, a company applies the cost of products to determine the ending inventory costs. The Cost of Goods Sold is calculated by adding the beginning inventory to the ending inventory and new purchases.
- Perpetual Inventory System: Since this system prefers continuous tracking of the Cost of Goods Sold, any new purchases are added to the current stock, and the average price is consequently determined.
WAC Compared To Other Common Inventory Valuation Methods
While inventory average is an efficient method to calculate the value of your current inventory, it may not be the best method for your business. To ensure that you are using the correct method for your business, it is important to weigh the advantages and disadvantages of each recommended method.
Remember that it is extremely important to stick to one method throughout a given tax period because switching methods before the next tax periods could result in numerous discrepancies.
So before you settle on a weighted average cost, ensure you are familiar with each of the inventory valuation methods outlined below and how they differ from WAC.
WAC vs First In, First Out (FIFO)
The main difference between the two methods is the cost attached to inventory that is sold. The FIFO method operates on the assumption that the inventory that was bought first will be the first to be sold. This impacts the cost of goods sold to a large extent because regardless of when inventory is sold, the cost allocated to that inventory will be the cost of the earliest inventories that the company bought.
Conversely, in WAC, inventory is dispatched based on the weighted average costs of all inventory that the business holds at the time of dispatch.
The FIFO method is often recommended for company’s that deal in perishables or products with a short shelf life.
The main disadvantage of the FIFO method is that it fails to take into account the fact that inventory costs could increase or decrease significantly, and using old values could negatively impact your profits or lead to incorrect reflections on your income statement.
FIFO is advantageous in the sense that most companies typically sell inventory in the order in which it’s bought, so it provides you with an accurate representation of the actual flow of goods in a business.
WAC vs Last In, Last Out (LIFO)
LIFO is the exact opposite of FIFO. It operates on the assumption that inventory bought last will be the first to be sold. When the prices of goods are high such as during inflation, the LIFO method results in a high COGS and a relatively low ending inventory.
It is important to note that LIFO is not accepted under the International Financial Reporting Standards (IFRS), which are the accounting rules followed within the European Union, Canada, Japan, Russia, and numerous other countries. The U.S however accepts LIFO because it is compliant with the General Accepted Accounting Principles (GAAP).
Industries impacted by rising costs generally prefer to use LIFO. For instance, pharmacies and supermarkets would prefer to use LIFO because most of their stocked goods experience inflation. When prices are rising, it would be in a company’s favor, especially those with large inventories, to use LIFO due to its ability to lower taxes.
LIPO is widely criticized for distorting a company’s balance sheet, particularly when there is inflation. It is also criticized for giving its users unfair tax cuts since it lowers net income, subsequently lowering the tax a company faces.
Specific Identification Method
This method provides the most accurate product unit cost because it tracks individual inventory items from the point of purchase to the point of sale.
It is recommended for small businesses or startups because they can keep track of every individual item in the inventory. It is however not a realistic method for large businesses.
Advantages of Using The WAC Method
The WAC method may be advantageous to your business in the following ways-
- Simplicity: This is perhaps the main advantage of using the inventory average method, making it suitable for new or small businesses alike. With the WAC method, there exists no need to determine the original cost of an item to price it.
- Time effective: it takes very little time to calculate the value of your inventory due to the simplicity of the WAC method.
- Consistency: as indicated earlier, profits derived from applying the LIFO or FIFO methods are based either on the most recent or oldest purchases. This means that if significant price changes occur, the cost of goods sold and gross margin reflected will be inaccurate and could lead to the company making poor purchasing decisions. The inventory average cost is consistent and would thus mirror accurate figures when the cost of goods sold is calculated.
- Less paperwork: to determine the inventory average cost, the WAC method requires only one cost calculation. Because all items in inventory are valued at the same amount, there is no need to keep numerous purchasing records, implying there is less paper trail to keep track of.
Disadvantages of Using WAC:
The WAC method may fail to favor your business due to the following reasons-
- Quantities may vary: this is perhaps the biggest disadvantage of the WAC method. Since it’s an average, it fails to account for varying quantities. While the method may work perfectly where the number of units and unit costs are almost similar, it may create inappropriate cost values where costs for different units vary significantly.
- This leads to poor cost management: in WAC, costs are lumped together in a general pool before being divided across the different items. This, therefore, means that cost managers can’t follow the costs of a particular product from the point of production to the point of sale. This in turn translates into vague cost management as it is hard to identify what cost was accrued by which product.
- Your company naturally employs the FIFO method: if your business sells perishable items, it’s highly likely that you naturally follow a first-in, first-out method when you are selling the items. It would therefore make no sense to deviate from this method seeing as the faster you sell old items, the less likely they are to go to waste.
- The most commonly applied inventory valuation methods are the Weighted Average Cost Method (WAC), First In First Out Method (FIFO), Last In First Out Method, and the Specific Identification Method.
- The Weighted Average Method is preferable where inventory is extremely similar in terms of cost and time of purchase.
- The First In First Out Method (FIFO) operates on the assumption that the first items to be purchased are the first items to be sold. It is preferred by businesses that stock perishable goods.
- The Last In First Out Method (LIFO) operates on the assumption that the last items to be bought are the first items to be sold.
Selecting the suitable inventory valuation method for your business is dependent on varying factors such as the location of your business, the extent to which your inventory varies, and whether your costs are decreasing or increasing.
Generally, the FIFO method is widely accepted by most business owners because it reflects the most accurate picture of costs and profitability. It is however important to note that there is no one-size-fits-all solution so it’s best to access all available options.
Inventory management and valuation get more complicated as a business grows. Businesses that do not find a way to optimally track their inventory are eventually unable to scale. By using applications such as Emerge that offer inventory management services, technology, and analytics, you will be able to grow your business to greater heights.
We at Emerge take care of your inventory management and allow you to focus on expanding your business and improving customer experience. Inventory management and tracking can be tedious, to avoid the headaches associated with it, partner with Emerge today.