Definition of Weighted Average Cost
The Weighted Average Cost (WAC) method is an inventory valuation approach under which businesses calculate both the cost of goods sold (COGS) and ending inventory by averaging the total cost of all inventory items available for sale during a period. This method aims to smooth out price fluctuations and reflect a more stable cost basis for inventory.
Examples
Example 1:
A company has the following inventory purchases and sales in January:
- Purchased 100 units at $10 each.
- Purchased 200 units at $12 each.
- Sold 150 units.
To calculate the weighted average cost per unit, we use the following formula:
\[ \text{Weighted Average Cost} \ =\ \frac{\text{Total Cost of Inventory}}{\text{Total Units Available}} \]
\[ \text{Total Cost of Inventory} = (100 \times $10) + (200 \times $12) = $1000 + $2400 = $3400 \]
\[ \text{Total Units Available} = 100 + 200 = 300 \]
\[ \text{Weighted Average Cost per Unit} = \frac{$3400}{300} = $11.33 \text{ per unit} \]
For COGS:
\[ \text{COGS} = 150 \times $11.33 = $1699.50 \]
For Ending Inventory:
\[ \text{Ending Inventory} = (300 - 150) \times $11.33 = 150 \times $11.33 = $1699.50 \]
Example 2:
A retail store begins the month with 50 units of an item costing $15 each. During the month, they purchase another 150 units at $18 each and sell 120 units.
\[ \text{Total Cost of Inventory} = (50 \times $15) + (150 \times $18) = $750 + $2700 = $3450 \]
\[ \text{Total Units Available} = 50 + 150 = 200 \]
\[ \text{Weighted Average Cost per Unit} = \frac{$3450}{200} = $17.25 \text{ per unit} \]
For COGS:
\[ \text{COGS} = 120 \times $17.25 = $2070 \]
For Ending Inventory:
\[ \text{Ending Inventory} = (200 - 120) \times $17.25 = 80 \times $17.25 = $1380 \]
Frequently Asked Questions (FAQs)
1. Why use the weighted average cost method?
The WAC method smoothens out price fluctuations and provides a more consistent cost basis, which can simplify inventory valuation and align with overall financial goals.
2. How does it compare to FIFO and LIFO?
- First-In, First-Out (FIFO) assigns the cost of the earliest inventory purchases to the cost of goods sold.
- Last-In, First-Out (LIFO) assigns the cost of the latest inventory purchases to the cost of goods sold.
- Weighted Average Cost assigns an average cost to all units.
3. What are the limitations of the WAC method?
The WAC method may not reflect current market conditions accurately. It can mask specific cost variations and lead to different tax and profit implications compared to FIFO and LIFO.
4. Is the WAC method allowed under IFRS and GAAP?
Yes, the weighted average cost method is allowed under both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP).
5. How often should the weighted average cost be calculated?
It can be calculated on a perpetual or periodic basis, depending on the company’s inventory accounting system and reporting requirements.
- Average Cost: The cost per unit calculated by dividing total production or purchase costs by the number of units.
- Cost of Goods Sold (COGS): The direct costs attributable to the production of goods sold by a company.
- Ending Inventory: The value of goods available for sale at the end of an accounting period.
- First-In, First-Out (FIFO): An inventory valuation method where the cost of the oldest items is assigned to the cost of goods sold.
- Last-In, First-Out (LIFO): An inventory valuation method where the cost of the newest items is assigned to the cost of goods sold.
Online References
- Investopedia on Weighted Average Cost
- AccountingTools Article
- Corporate Finance Institute
Suggested Books for Further Studies
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield.
- “Accounting Made Simple: Accounting Explained in 100 Pages or Less” by Mike Piper.
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan.
Accounting Basics: “Weighted Average Cost” Fundamentals Quiz
### What is the primary goal of the weighted average cost method?
- [ ] To use the cost of the latest inventory purchases.
- [ ] To use the cost of the earliest inventory purchases.
- [x] To average the total cost of all units available for sale.
- [ ] To compute the lowest possible cost of goods sold.
> **Explanation:** The primary goal of the weighted average cost method is to average the total cost of all units available for sale to smoothen out price fluctuations.
### How is the weighted average cost per unit calculated?
- [ ] By summing the costs of the latest purchases.
- [ ] By taking the average of the first and last purchase costs.
- [x] By dividing the total cost of inventory by the total units available.
- [ ] By using the median cost of all units purchased.
> **Explanation:** The weighted average cost per unit is calculated by dividing the total cost of inventory by the total units available.
### In the context of the weighted average cost method, what does COGS stand for?
- [ ] Costs of Great Sales
- [ ] Costs of General Stores
- [x] Cost of Goods Sold
- [ ] Calculations of Goods Sold
> **Explanation:** COGS stands for Cost of Goods Sold, which represents the direct costs attributable to the production of goods sold by a company.
### What happens to ending inventory value when using the weighted average cost method?
- [ ] It reflects the value of the oldest items purchased.
- [ ] It matches the value of the newest items purchased.
- [x] It reflects the average cost of all units available.
- [ ] It is determined based on the highest purchase price.
> **Explanation:** When using the weighted average cost method, the ending inventory value reflects the average cost of all units available during the period.
### What is the impact of price fluctuations on the weighted average cost method?
- [ ] It eliminates price fluctuations entirely.
- [x] It smoothens out price fluctuations.
- [ ] It exaggerates price variability.
- [ ] It amplifies differences between purchase costs.
> **Explanation:** The weighted average cost method smoothens out price fluctuations by averaging the costs, leading to a more consistent cost basis.
### Which accounting frameworks allow the use of the weighted average cost method?
- [ ] IFRS only
- [ ] GAAP only
- [x] Both IFRS and GAAP
- [ ] Neither IFRS nor GAAP
> **Explanation:** Both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) allow the use of the weighted average cost method.
### Which inventory valuation method assigns the cost of the earliest items to COGS?
- [x] FIFO
- [ ] LIFO
- [ ] Weighted Average Cost
- [ ] Standard Costing
> **Explanation:** FIFO (First-In, First-Out) assigns the cost of the earliest inventory purchases to the cost of goods sold.
### How often should companies calculate the weighted average cost to maintain accuracy?
- [ ] Once a year
- [x] Periodically or perpetually
- [ ] Only at the end of the fiscal year
- [ ] Every quarter
> **Explanation:** Companies should calculate the weighted average cost periodically or perpetually to maintain accuracy and relevance in their inventory valuations.
### In periods of rising prices, how does the weighted average cost compare to FIFO in terms of COGS?
- [x] WAC results in a higher COGS than FIFO.
- [ ] WAC results in a lower COGS than FIFO.
- [ ] WAC has the same COGS as FIFO.
- [ ] WAC results in lower net income than FIFO.
> **Explanation:** In periods of rising prices, the weighted average cost method tends to result in a higher cost of goods sold compared to FIFO, as it averages out the higher prices paid during the period.
### Which type of businesses can benefit the most from using the weighted average cost method?
- [ ] Businesses with highly variable inventory costs.
- [ ] Businesses with non-perishable goods.
- [x] Businesses with stable inventory prices.
- [ ] Businesses with a high turnover rate.
> **Explanation:** Businesses with stable inventory prices can benefit the most from using the weighted average cost method as it simplifies inventory valuation and ensures consistency over time.
Thank you for exploring the fundamentals of the weighted average cost method and taking our quiz. Keep advancing your accounting knowledge for continued success!
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