Valuation of Inventory: Weighted Average
The weighted average method is used to assign the average cost of production to a product. Weighted average costing is commonly used in situations where:
Inventory items are so intermingled that it is impossible to assign a specific cost to an individual unit.
The accounting system is not sufficiently sophisticated to track FIFO or LIFO inventory layers.
Inventory items are so commoditized (i.e., identical to each other) that there is no way to assign a cost to an individual unit.
When using the weighted average method, divide the cost of goods available for sale by the number of units available for sale, which yields the weighted-average cost per unit. In this calculation, the cost of goods available for sale is the sum of beginning inventory and net purchases. You then use this weighted-average figure to assign a cost to both ending inventory and the cost of goods sold.
The net result of using weighted average costing is that the recorded amount of inventory on hand represents a value somewhere between the oldest and newest units purchased into stock. Similarly, the cost of goods sold will reflect a cost somewhere between that of the oldest and newest units that were sold during the period.
The weighted average method is allowed under both generally accepted accounting principles and international financial reporting standards.
Weighted Average Costing Example
Milagro Corporation elects to use the weighted-average method for the month of May. During that month, it records the following transactions:
|Ending inventory||= 175|
The actual total cost of all purchased or beginning inventory units in the preceding table is $116,000 ($33,000 + $54,000 + $29,000). The total of all purchased or beginning inventory units is 450 (150 beginning inventory + 300 purchased). The weighted average cost per unit is therefore $257.78 ($116,000 ÷ 450 units.)
The ending inventory valuation is $45,112 (175 units × $257.78 weighted average cost), while the cost of goods sold valuation is $70,890 (275 units × $257.78 weighted average cost). The sum of these two amounts (less a rounding error) equals the $116,000 total actual cost of all purchases and beginning inventory.
In the preceding example, if Milagro used a perpetual inventory system to record its inventory transactions, it would have to recompute the weighted average after every purchase. The following table uses the same information in the preceding example to show the recomputations:
Cost of Sales
|Inventory Moving- Average
|Beginning inventory||150||$ —||$ —||$33,000||$220.00|
|Sale (125 units @ $220)||25||—||27,500||5,500||220.00|
|Purchase (200 units @ $270)||225||54,000||—||59,500||264.44|
|Sale (150 units @ $264.44)||75||—||39,666||19,834||264.44|
|Purchase (100 units @ $290)||175||29,000||—||48,834||279.05|
Note that the cost of goods sold of $67,166 and the ending inventory balance of $48,834 equal $116,000, which matches the total of the costs in the original example. Thus, the totals are the same, but the moving weighted average calculation results in slight differences in the apportionment of costs between the cost of goods sold and ending inventory.