As with nearly every aspect of financial tracking, accounting allows small businesses to choose different ways to record transactions as long as you follow the Generally Accepted Accounting Principles (GAAP). Consider, for instance, the number of companies that employ the cash-basis approach versus the accrual method of accounting. Well, one of the most obvious differences when it comes to the accounting methods boils down to the way that companies record their inventory cost also known as inventory valuation which takes into account the beginning inventory to ending inventory balance. Out of the three alternatives, the weighted average cost or WAC method is considered to perpetuate the least number of misstatements due to time-based limitations. So, what exactly is this method and how does it work?
The weighted average method, whether using the periodic inventory system or the perpetual inventory system, is used when a company assigns the average cost of production to their products. Both the periodic system and the perpetual system are acceptable methods under the GAAP. Expectedly, since that number is derived by relying on a weighted average, it will be skewed towards the actual total cost of those inventory items with the most total number of units. To better comprehend what weighted average accounting means, consider the following scenario:
Company purchases 90 individual units for $36,000, 50 physical units for $20,000, and 260 for $108,000. Additionally, the beginning balance in the inventory account was 100 units at $40,000. Naturally, these transactions took place at three different points in time. For the purposes of this discussion, however, one can ignore the sales that occurred between each purchase. So, in order to derive the average cost of goods (cogs), all of the expenses will be combined and divided by the cumulative number of equivalent units to determine the average unit cost.
Therefore, the weighted-average cost for the aforementioned scenario will be $408 ($204,000 divided by 500 total units).
Cost Flow Assumptions
Just like with LIFO method and FIFO method calculation, the weighted average method is a way that companies will assign costs to their products that get moved from finished inventory levels to the sold goods. In other words, the previous average cost of $408 will be how much gets debited to the expense account called the “Cost of Goods Sold” while the selling price gets entered as a credit to the “Sales” account.
Once all of the sales are accumulated at the end of the fiscal year or end of the accounting period, the total cost of goods sold will be the first line item that must be subtracted. The difference between those two will offer something called “operational income” that then goes through further subtractions at the end of the year.
What Companies Would Use The Weighted Average Method?
Generally speaking, companies that may have difficulty distinguishing between older and newer inventory will rely on the weighted average formula. After all, both FIFO (first-in first-out) and LIFO system (last-in first items out) are based on knowing when a certain unit was produced. So, think about the manufacturers who create thousands of the exact same products every day.
Additionally, most agricultural businesses will use this method. Failing to do so could mean that they must know when beans or corn were produced on an individual basis. Well, that would quite literally be impossible to do since these companies produce millions of seeds of beans daily.
Lastly, organizations that deal with chemicals or fuel are often going to use the valuation methods of average cost method over FIFO or LIFO. This is because the vast majority of all fuel producers combine batches and, in turn, make it impossible to determine which gallon of fuel was produced first. So, the bottom-line objective is to permit businesses to simplify their accounting practice when using FIFO or LIFO would create an undue hardship.