Weighted Average Costs (WAC) in Inventory Valuation
Inventory management is the backbone of any supply chain and business operations. Companies must track inventory accurately to ensure efficient operations, avoid stockouts, and minimize holding costs. Among the different costing methods used in inventory management, the Weighted Average Cost (WAC) method is one of the most popular.
In this blog post, we will dive deep into what the WAC method is, how it works, and its advantages and disadvantages in managing inventory effectively.
What is Weighted Average Cost (WAC) in Inventory Management?
Weighted Average Cost (WAC) is an inventory valuation method that calculates the average cost of all inventory items, regardless of when they were purchased over a particular accounting period. Instead of tracking the cost of individual items, WAC averages the inventory cost of all items in stock as weighted cost. This provides a single, consistent figure for the cost of inventory and simplifies the process of determining the cost of goods sold (COGS).
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What's The Weighted Average Cost Formula?
To calculate weighted average cost for your inventory, simply divide the cost of goods available for sale by the number of inventory units you have on hand.
The WAC formula looks like this:
WAC=Total Cost of Goods Available for SaleTotal Units Available for Sale/Total Number of Units on Hand
In simple terms, the weighted average method adds up the total cost of all inventory and divides it by the number of units available for sale. This gives an average cost per unit, which is used to value both the inventory and the cost of goods sold.
Let’s quickly run through an example to help you understand the concept much better:
Suppose a business makes the following inventory purchases during a month:
100 units at $5 each
200 units at $6 each
150 units at $7 each
The total cost of goods available for sale is: (100 x $5) + (200 x $6) + (150 x $7) = $500 + $1,200 + $1,050 = $2,750
The total number of units available for sale is: 100 + 200 + 150 = 450 units
To calculate the weighted average cost, we divide the total cost by the total number of units:
WAC = 2750/450 = 6.1
So, the weighted average cost per unit is $6.11. This average cost is applied when valuing the remaining inventory and determining the cost of goods sold (COGS).
The Benefits of Using Weighted Average Cost Method in Inventory Valuation
Leveraging the weighted average cost method can help you to accurately evaluate your company’s financial health. The other benefits it offers are as follows:
1. Simplicity and Ease of Use
One of the biggest advantages of the WAC method is its simplicity. Unlike other inventory valuation methods like FIFO (First-In-First-Out) or LIFO (Last-In-First-Out), which require tracking the cost of individual items or batches, WAC averages all costs across the inventory. This simplifies calculations, especially for businesses with high inventory turnover or those dealing with a large volume of goods. It also helps to keep an accurate tab on your inventory levels.
By using a single average cost for all inventory items, businesses can avoid the complexity of managing detailed cost records for each product. This simplicity reduces administrative burdens and minimizes the potential for errors.
2. Stabilizes Inventory Valuation
The WAC method smooths out the impact of price fluctuations. In industries where prices change frequently—due to market conditions, supplier pricing changes, or seasonal variations—WAC averages these changes over time. This results in more stable and consistent financial reporting.
For example, if a company buys the same product at different prices throughout the year, WAC ensures that no single purchase drastically affects the valuation of inventory or the cost of goods sold. This stability is especially valuable for businesses that want to avoid sudden fluctuations in profits or inventory values.
3. Reduces the Impact of Inflation and Price Changes
In times of rising prices (inflation), the WAC method helps mitigate the effect of purchasing goods at higher costs. Instead of directly reflecting the most recent, expensive purchases in the COGS (as LIFO does), WAC averages all costs. This can be advantageous because it prevents a sharp increase in COGS, which could negatively impact profitability.
Likewise, during deflation or when prices drop, WAC avoids dramatically reducing the value of inventory or increasing profits artificially. It ensures a balanced, averaged approach to reflecting inventory costs.
4. Ideal for High-Volume and Low-Cost Items
For businesses that deal with large volumes of low-cost items—such as retailers, wholesalers, or manufacturers—the WAC method is an ideal fit. In such industries, tracking the cost of individual items would be impractical and time-consuming. Instead, WAC provides a practical way to manage inventory costs efficiently, ensuring that all items are valued consistently, regardless of individual purchase prices.
This is particularly useful for businesses that restock their inventory frequently or deal with items that have relatively small price differences between purchases.
5. Compliance with International Financial Reporting Standards (IFRS)
The Weighted Average Cost method is compliant with International Financial Reporting Standards (IFRS), making it a popular choice for businesses that operate globally. Unlike LIFO, which is not allowed under IFRS, WAC offers a method that can be used across various jurisdictions without conflicting with international accounting standards.
Comparing the Weighted Average Cost (WAC) Method with Other Inventory Costing Methods
Weighted average cost isn’t the only method used to determine inventory value; the FIFO and LIFO methods are also sometimes used for this purpose. Each method has its own benefits and drawbacks, making it important for businesses to understand how they differ.
First-In-First-Out (FIFO)
The First-In-First-Out (FIFO) method assumes that the oldest inventory items are sold first. This means that the cost of goods sold (COGS) reflects the price of the earliest purchased items, while the value of ending inventory reflects the most recent prices.
Pros of FIFO:
Increases profitability in times of inflation, as older, cheaper items are recorded as COGS, leading to lower costs and higher profits.
Ending inventory is valued higher, since it reflects more recent, often higher purchase costs.
Good for perishable items (e.g., food, pharmaceuticals), as it aligns with physical stock rotation.
Cons of FIFO:
Inflates taxable income in times of rising prices, as lower COGS leads to higher profits, which can result in higher tax liabilities.
Not always reflective of current market conditions, especially when prices have changed significantly since older inventory was purchased.
Last-In-First-Out (LIFO)
The Last-In-First-Out (LIFO) method assumes that the newest inventory items are sold first. Under LIFO, the COGS reflects the cost of the most recently purchased inventory, while ending inventory reflects older, lower-priced items.
Pros of LIFO:
Tax benefits during inflation, as COGS is based on more expensive, newer inventory, which reduces taxable income and leads to tax savings.
Better reflects current market costs in the COGS, as the most recent purchases are sold first.
Cons of LIFO:
Ending inventory is undervalued, since older, cheaper items remain on the books, which can distort the balance sheet.
Not allowed under IFRS, limiting its use to businesses operating under U.S. Generally Accepted Accounting Principles (GAAP).
Can result in lower profits in periods of rising prices, due to higher COGS.
When to Use Each Method
WAC is ideal for businesses with large volumes of similar items, frequent price changes, and those that prefer simplicity and consistency in financial reporting. It’s also a good fit for businesses operating internationally due to its IFRS compliance.
FIFO is best suited for businesses in industries where the oldest items should be sold first, such as food and pharmaceuticals. It’s also advantageous during periods of inflation if the company wants to report higher profits and maintain a higher inventory valuation.
LIFO works well for businesses that want to reduce taxable income in inflationary times. However, it’s only an option for companies operating under U.S. GAAP, limiting its global use.
Conclusion
The Weighted Average Cost (WAC) method is a simple and effective way to manage inventory costs, especially for companies that deal with fluctuating prices and large volumes of stock. While it has its disadvantages, particularly in rapidly changing markets, WAC offers a fair and balanced approach to inventory valuation, smoothing out price fluctuations and simplifying cost management.
Choosing the right inventory costing method is vital to ensuring accurate financial reporting and effective inventory control. Businesses should carefully assess their needs and market conditions before deciding whether the WAC method, or another approach, is the best fit for their operations.
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