Inventory Accounting

Inventory accounting may sound like a huge undertaking but in reality, it is quite straightforward and easy to understand. You start with the inventory you have on hand. No matter when you sell product, the value of your inventory will remain constant based on accepted and rational methods of inventory accounting. Those methods include weighted average, first in/first out, and last in/first out.

Weighted average

Weighted average measures the total cost of items in inventory that are available for sale divided by the total number of units available for sale. Typically this average is computed at the end of an accounting period.

When using the weighted average method, you 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.

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.

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.

Average cost method (AVCO) calculates the cost of ending inventory and cost of goods sold for a period on the basis of weighted average cost per unit of inventory. Weighted average cost per unit is calculated using the following formula:

Weighted Average = Total Cost of Inventory

Unit Cost Total Units in Inventory Like FIFO and LIFO methods, AVCO is also applied differently in periodic inventory system and perpetual inventory system. In periodic inventory system, weighted average cost per unit is calculated for the entire class of inventory. It is then multiplied with number of units sold and number of units in ending inventory to arrive at cost of goods sold and value of ending inventory respectively. In perpetual inventory system, we have to calculate the weighted average cost per unit before each sale transaction.

The main difference between weighted average cost accounting, LIFO, and FIFO methods of accounting is the difference in which each method calculates inventory and cost of goods sold.The weighted average cost method uses the average of the costs of the goods to assign costs. In other words, weighted average uses the formula: Total cost of items in inventory available for sale divided by total number of units available for sale.

In contrast, FIFO (first in, first out) accounting means that the costs assigned to goods are the costs for the first goods bought. In other words, the company assumes that the first goods sold are the oldest or the first goods bought. On the other hand, LIFO (last in first out) assumes that the last or latest items bought are the first items to be sold. The costs of goods under weighted average will be between the cost levels determined by FIFO and LIFO. FIFO is preferable in times of rising prices, so that the costs recorded are low and income is higher, while LIFO is preferable in times when tax rates are high because the costs assigned will be higher and income will be lower.

The calculation of inventory value under average cost method is explained with the help of the following example:

Example

Apply AVCO method of inventory valuation on the following information, first in periodic inventory system and then in perpetual inventory system to determine the value of inventory on hand on Mar 31 and cost of goods sold during March. Mar 1 Beginning Inventory 60 units @ $15.00 per unit 5 Purchase 140 units @ $15.50 per unit 14 Sale 190 units @ $19.00 per unit 27 Purchase 70 units @ $16.00 per unit 29 Sale 30 units @ $19.50 per unit

Solution

AVCO Periodic

Units Available for Sale = 60 + 140 + 70 = 270 Units Sold = 190 + 30 = 220

Units in Ending Inventory = 270 − 220 = 50

Weighted Average Unit Cost Units Unit Cost Total

Mar 1 Inventory 60 $15.00 $900

Mar 5 Purchase 140 $15.50 $2,170

27 Purchase 70 $16.00 $1,120

270 * $15.52 $4,190

* $4,190 ÷ 270

Cost of Goods Sold 220 $15.52 $3,414

Ending Inventory 50 $15.52 $776

AVCO Perpetual

Purchases Sales Balance

Date Unit Unit Unit Units Total Units Total Units Total Cost Cost Cost

Mar 60 $15.00 $900 1

5 140 $15.50 $2,170 60 $15.00 $900

140 $15.50 $2,170

200 $15.35 $3,070

14 190 $15.35 $2,916 10 $15.35 $154

27 70 $16.00 $1,190 10 $15.35 $154

70 $16.00 $1,120

80 $15.92 $1,274 29 30 $15.92 $478 50 $15.92 $796

31 50 $15.92 $796