Weighted Average Method, Work, Advantages and Disadvantages

Weighted Average Method is a popular inventory valuation method that calculates the average cost of all goods available for sale during a period. This method is widely used in both cost accounting and financial accounting to determine the cost of goods sold (COGS) and the value of inventory on hand. The weighted average method assigns a single cost to all units of inventory, regardless of when the units were purchased. It works by averaging the cost of inventory items, taking into account both the number of units and the cost of each unit.

How the Weighted Average Method Works:

In the weighted average method, the total cost of all inventory items purchased during the period is divided by the total number of units available for sale. This gives the average cost per unit, which is then used to value both the cost of goods sold (COGS) and the ending inventory.

Formula:

Weighted Average Cost per Unit = Total Cost of Goods Available for Sale / Total Units Available for Sale​

Where:

• Total Cost of Goods Available for Sale = (Opening Inventory + Purchases during the period)
• Total Units Available for Sale = (Opening Inventory Quantity + Purchases during the period)

Once the weighted average cost per unit is calculated, it is applied to both the units sold and the units remaining in inventory at the end of the period.

Example:

Let’s take a simple example of a company that buys and sells a single product throughout a year.

1. Opening Inventory (January 1):
   • 100 units at $10 each.
2. Purchases:
   • January 15: 200 units at $12 each.
   • February 10: 300 units at $14 each.
3. Total Purchases and Sales:
   • Sales in February: 400 units.

Step 1: Calculate Total Cost of Goods Available for Sale

• Opening Inventory: 100 units × $10 = $1,000
• Purchases on January 15: 200 units × $12 = $2,400
• Purchases on February 10: 300 units × $14 = $4,200

Total Cost of Goods Available for Sale:

Total Cost = 1,000 + 2,400 + 4,200 = 7,600

Total Units Available for Sale:

Total Units = 100 + 200 + 300 = 600

Step 2: Calculate Weighted Average Cost per Unit

Weighted Average Cost per Unit = 7,600 / 600 = 12.67

Step 3: Apply the Weighted Average Cost to Sales

Since 400 units are sold in February, the cost of goods sold (COGS) will be:

COGS = 400 units × 12.67 = 5,068

Step 4: Calculate Ending Inventory

At the end of February, the company has 200 units left in inventory (600 units available for sale – 400 units sold). The value of the remaining inventory will be:

Ending Inventory = 200 units × 12.67 = 2,534

Advantages of the Weighted Average Method:

• Simplicity:

The weighted average method is relatively simple to use, especially for companies with large volumes of inventory transactions. It requires fewer calculations compared to other methods like FIFO and LIFO.

• Smoothens Price Fluctuations:

Since the weighted average method takes the average cost of all units, it smoothens out the effects of price fluctuations in the inventory. This can be particularly useful when prices are volatile.

• Prevents Manipulation:

The weighted average method provides a consistent and less manipulable approach to inventory valuation.

• Simplifies Record-Keeping:

The method simplifies record-keeping by reducing the need to track individual unit costs as is required under FIFO and LIFO. This can save time and reduce errors in accounting systems.

• Effective for Homogeneous Products:

The weighted average method works well for businesses that deal with large quantities of similar or identical items, such as retail or manufacturing companies.

Disadvantages of the Weighted Average Method:

• May Not Reflect Current Costs:

Since the weighted average method smooths out cost fluctuations, it may not reflect the most current costs of inventory. In periods of rising prices, it can underestimate the actual cost of goods sold and overstate inventory value.

• Lacks Detail in Cost Allocation:

The method aggregates all costs, so it doesn’t provide specific details about the cost of individual inventory purchases. In certain businesses, such as those dealing with customized goods or perishable products, this may not give an accurate representation of cost.

• Not Suitable for All Industries:

While it works well for industries with homogenous inventory, the weighted average method may not be suitable for industries dealing with diverse, high-value products (e.g., cars, real estate, etc.) where each item has a significantly different cost.

• May Not Align with Physical Flow:

The method assumes that all units are identical, but this may not reflect the physical movement of inventory. For instance, a company selling perishable items might sell older stock first, which may not align with the weighted average cost.

Applications of the Weighted Average Method:

The weighted average method is commonly used in industries where inventory items are indistinguishable or where inventory turnover is high. Some typical examples:

• Retail:

Retailers often use the weighted average method for products that are of similar nature, like clothing, food products, and electronics.

• Manufacturing:

Manufacturing companies dealing with raw materials, parts, and components often use this method to calculate the cost of goods sold, as raw material prices can fluctuate.

• Agriculture:

Agricultural businesses often use the weighted average method to account for inventory, especially if they are selling bulk crops or livestock with fluctuating costs.

• Commodity Trading:

Companies in the commodity trading business often use the weighted average method to calculate the cost of goods sold because commodity prices fluctuate significantly.