When it comes to businesses and their inventory and accounting methods for managing it, there are a few different ways to approach the task. The three different options to value inventory/implement cost flow assumptions, include: Last In, First Out (LIFO); First In, First Out (FIFO); and Weighted Average Cost Accounting (WAC). This article will focus only on the WAC method.
Weighted Average Cost (WAC) Method
WAC is a way to value inventory based on how much each tranche contributes to the overall valuation of its cost of goods sold (COGS) and inventory. Recognized by both GAAP and IFRS, it’s determined by taking the cost of goods available for sale and dividing it by the quantity of inventory ready to be sold. It’s important to note that while WAC is a generally accepted accounting principle, it’s not as precise as FIFO or LIFO; however, it is effective at assigning average cost of production to a given product.
It’s done primarily for types of inventories where parts are so intertwined that it makes it problematic to attribute clear-cut expenditures to a particular part. This often happens when stockpiles of parts are indistinguishable from each other. It also accounts for businesses offering their inventory for sale all at once. Here’s a visual representation of the formula:
Weighted Average Cost (WAC) Method Formula
WAC per unit = Cost of goods available for sale / Units available for sale
Costs of goods available for sale is determined by adding new purchases of inventory to the value of what the business already had in its existing stock. Units available for sale is how many saleable items the company possesses. Its value is assessed per item and encompasses starting inventory and additional purchases.
When it comes to calculating WAC, there are two different types of inventory analysis systems: periodic and perpetual.
Periodic Inventory System
In this system, the business tallies its inventory at the end of the accounting period – be it a quarter, half or fiscal year – and analyzes how much the inventory costs. This then determines the value of the remaining inventory. The COGS is then calculated by adding how much starting, final, and additional inventory within the accounting period cost.
Perpetual Inventory System
This system puts a bigger emphasis on more real-time management of its stock levels. The trade-off for such real-time tracking of inventory requires more company financial resources. Looking at an example of how a company began its fiscal year with the following inventory can illustrate how it works.
At the beginning of the year, a company had 1,000 units, costing $50 per unit. It also made three additional inventory purchases going forward.
Jan 20: 75 units costing $100 = $7,500
Feb 17: 150 units costing $150 = $22,500
March 18: 300 units costing $200 = $60,000
During the fiscal year, the business sold:
235 units sold during the last week of February
325 units sold during the last week of March
Looking at the Periodic Inventory System, for the first three months of its fiscal year, the company can determine its COGS and the number of items ready to be sold over the first three months of its fiscal year.
WAC per item – ($50,000 + $7,500 + $22,500 + $60,000) / 1,525 = $91.80
Based on this method, the WAC per unit would be multiplied by the number of units sold during the accounting period, therefore:
560 units x $91.80 = $51,408 (inventory sold)
To calculate the final inventory value, we take the entire purchase cost and subtract the remaining inventory to arrive at the valuation:
$140,000 – $51,408 = $88,592
Perpetual Inventory System
Unlike the periodic inventory system, this looks at determining the mean prior to the transaction of items:
This would calculate the average before the 235 units were sold during the last week of February:
WAC for each item: ($50,000 + $7,500 + $22,500) / 1,225 = $65.31
Looking at the 235 units sold during the last week of February, it’s calculated as follows:
235 x $65.31 = $15,347.85 (inventory sold)
$80,000 – $15,347.85 = $64,652.15 (remaining inventory value)
Before calculating for the 325 units sold the last week of March, the unit valuation per WAC is: ($64,652.15 + $60,000) / (1225 – 235 + 300) = 1290 = $96.63
Looking at the 325 units sold during the last week of March is calculated as follows:
325 x $96.63 = $31,404.75 (inventory sold)
$124,652.15 – $31,404.75 = $93,247.40 (remaining inventory)
Based on these options, businesses have the choice, along with LIFO and FIFO, to decide how they want to vary it based on their own business needs.