The weighted average for the year inventory cost flow method is applicable to which inventory system

Weighted Average vs. FIFO vs. LIFO: An Overview

When it comes time for businesses to account for their inventory, businesses may use the following three primary accounting methodologies:

Weighted average cost accounting
Last in, first out (LIFO) accounting
First in, first out (FIFO) accounting

Each of these three methodologies relies on a different method of calculating both the inventory of goods and the cost of goods sold. Depending on the situation, each of these systems may be appropriate.

Key Takeaways

When it comes time for businesses to account for their inventory, they typically use one of three different primary accounting methodologies: the weighted average method, the first in, first out (FIFO) method, or the last in, first out (LIFO) method.
The weighted average method is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit.
The first in, first out (FIFO) accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time.
The last in, first out (LIFO) accounting method assumes that the latest items bought are the first items to be sold.

Weighted Average

The weighted average method, which is mainly utilized to assign the average cost of production to a given product, is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit. This is frequently the case when the inventory items in question are identical to one another. Furthermore, this method assumes a store sells all of its inventories simultaneously.

To use the weighted average model, one divides the cost of the goods that are available for sale by the number of those units still on the shelf. This calculation yields the weighted average cost per unit—a figure that can then be used to assign a cost to both ending inventory and the cost of goods sold.

While the weighted average method is a generally accepted accounting principle, this system doesn’t have the sophistication needed to track FIFO and LIFO inventories.

First In, First Out (FIFO)

The first in, first out (FIFO) accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time. When a business uses FIFO, the oldest cost of an item in an inventory will be removed first when one of those items is sold. This oldest cost will then be reported on the income statement as part of the cost of goods sold.

Last In, First Out (LIFO)

The last in, first out (LIFO) accounting method assumes that the latest items bought are the first items to be sold. With this accounting technique, the costs of the oldest products will be reported as inventory. It should be understood that, although LIFO matches the most recent costs with sales on the income statement, the flow of costs does not necessarily have to match the flow of the physical units.

Generally speaking, FIFO is preferable in times of rising prices, so that the costs recorded are low, and income is higher. Contrarily, LIFO is preferable in economic climates when tax rates are high because the costs assigned will be higher and income will be lower.

Weighted Average vs. FIFO vs. LIFO Example

Consider this example: Suppose you own a furniture store and you purchase 200 chairs for $10 per unit. The next month, you buy another 300 chairs for $20 per unit. At the end of an accounting period, let's assume you sold 100 total chairs. The weighted average costs, using both FIFO and LIFO considerations are as follows:

200 chairs at $10 per chair = $2,000. 300 chairs at $20 per chair = $6,000
Total number of chairs = 500

Weighted Average Cost

Cost of a chair: $8,000 divided by 500 = $16/chair
Cost of Goods Sold: $16 x 100 = $1,600
Remaining Inventory: $16 x 400 = $6,400

First In, First Out Cost

Cost of goods sold: 100 chairs sold x $10 = $1,000
Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) = $7,000

Last In, First Out Cost

Cost of goods sold: 100 chairs sold x $20 = $2,000
Remaining Inventory: (200 chairs x $10) + (200 chairs x $20) = $6,000

The use of a weighted average to determine the amount that goes into COGS and inventory

What is Weighted Average Cost (WAC)?

In accounting, the Weighted Average Cost (WAC) method of inventory valuation uses a weighted average to determine the amount that goes into COGS and inventory. The weighted average cost method divides the cost of goods available for sale by the number of units available for sale. The WAC method is permitted under both GAAP and IFRS accounting.

Weighted Average Cost (WAC) Method Formula

The formula for the weighted average cost method is as follows:

Where:

Costs of goods available for sale is calculated as beginning inventory value + purchases.
Units available for sale are the number of units a company can sell or the total number of units in inventory and is calculated as beginning inventory in units + purchases in units.

Understanding Costs of Goods Available for Sale

The bundling of costs is referred to as the cost of goods available for sale. The costs of goods available for sale are either allocated to COGS or ending inventory. Allocating the costs of goods available for sale is referred to as a cost flow assumption. There are several cost flow assumptions, such as:

FIFO (first-in, first-out)
LIFO (last-in, first-out)
WAC (weighted average cost)

The WAC Method under Periodic and Perpetual Inventory Systems

Using the weighted average cost method yields different allocation of inventory costs under a periodic and perpetual inventory system.

In a periodic inventory system, the company does an ending inventory count and applies product costs to determine the ending inventory cost. COGS can then be determined by combining the ending inventory cost, beginning inventory cost, and the purchases throughout the period.

A perpetual inventory system keeps continual tracking of inventories and COGS. The perpetual inventory system provides more timely information for the management of inventory levels. However, this method of inventory tracking can be costly for a company. In a perpetual inventory system, the weighted average cost method is referred to as the “moving average cost method.”

Below, we will use the weighted average cost method and identify the difference in the allocation of inventory costs under a periodic and perpetual inventory system.

Example of the WAC Method

At the beginning of its January 1 fiscal year, a company reported a beginning inventory of 300 units at a cost of $100 per unit. Over the first quarter, the company made the following purchases:

January 15 purchase of 100 units at a cost of $130 = $13,000
February 9 purchase of 200 units at a cost of $150 = $30,000
March 3 purchase of 150 units at a cost of $200 = $30,000

In addition, the company made the following sales:

End of February sales of 100 units
End of March sales of 70 units

Under the periodic inventory system, we would determine the cost of goods available for sale and the units available for sale at the end of the first quarter:

For the sale of 170 units over the January-March period, we would allocate $137.33 per unit sold. The rest would go into ending inventory. Therefore:

170 x $137.33 = $23,346.10 in COGS
$103,000 – $23,346.10 = $79,653.90 in ending inventory

Note: The numbers may be slightly off due to rounding off.

Under the perpetual inventory system, we would determine the average before the sale of units.

Therefore, before the sale of 100 units in February, our average would be:

For the sale of 100 units in February, the costs would be allocated as follows:

100 x $121.67 = $12,167 in COGS
$73,000 – $12,167 = $60,833 remain in inventory

Note: The numbers may be slightly off due to rounding off.

Before the sale of 70 units in March, our average would be:

For the sale of 70 units in March, the costs would be allocated as follows:

70 x $139.74 = $9,781.80 in COGS
$90,833 – $9,781.0 = $81,051.20 in ending inventory

Note: The numbers may be slightly off due to rounding off.

The diagrams would look as follows under the perpetual inventory system:

Comparing the WAC Method under the Periodic and Perpetual Inventory Systems

Comparing the costs allocated to COGS and inventory, we can see that the costs are allocated differently depending on whether it is a periodic or perpetual inventory system. However, notice that the total costs remain the same (as they should).

In our example, the inventories purchased experienced a price appreciation. January purchase costs per unit were $130, February purchase costs per unit were $150, and March purchase costs per unit were $200. Therefore, since the periodic system uses the costs of goods available for sale over the entire quarter, more is allocated to the costs of goods sold for the sale of inventory.

Thank you for reading CFI’s guide to Weighted Average Cost. To keep learning and advance your career, the following CFI resources will be helpful:

Days Inventory Outstanding (DIO)
Inventory Turnover
Cost of Goods Manufactured (COGM)
Financial Accounting Theory

What company uses the weighted average method for inventory costing?

Fuel Companies The gas and petroleum industries utilize the weighted average costing method for inventory purposes. The extraction, collection and storage of liquid fuels and related products makes it necessary for those involved in both the manufacture and sale of these products to use this inventory method.

What is the weighted average cost flow method?

The weighted-average cost flow assumption is a costing method that is used to assign costs to inventory and the cost of goods sold. Under this approach, the cost of goods available for sale is divided by the number of units produced in the period to arrive at an average cost per unit.

Is weighted average cost of inventory?

What is Weighted Average Cost (WAC)? In accounting, the Weighted Average Cost (WAC) method of inventory valuation uses a weighted average to determine the amount that goes into COGS and inventory. The weighted average cost method divides the cost of goods available for sale by the number of units available for sale.

How is the weighted average cost of an inventory item calculated?

To calculate the weighted average cost, divide the total cost of goods purchased by the number of units available for sale. To find the cost of goods available for sale, you'll need the total amount of beginning inventory and recent purchases.