Understanding the Weighted Average Method in Inventory Valuation with Zoho Inventory

14.09.23 06:14 PM By CreatorScripts

Introduction

Welcome back to “Zoho Inventory Videos,” the definitive series where we break down complex inventory concepts into digestible insights. If you’ve been following along, you’ll recall our exploration of inventory valuation techniques, notably FIFO and LIFO, in our prior episodes. Today, we venture into the realm of the inventory weighted average cost method, a dynamic and unique approach to inventory management software valuation. Unlike FIFO (First-In, First-Out) and LIFO (Last-In, First-Out), which revolve around the sequencing of stock intake and release, the weighted average method offers a holistic viewpoint, taking all stock purchases into account to determine an average cost. As we delve deeper into inventory weighted average cost, you’ll discover its intricacies, benefits, and how it holds up against FIFO and LIFO. Whether you’re a seasoned business owner, an inventory novice, or someone keen on understanding the financial mechanics behind the scenes, this episode promises to enlighten you. Let’s embark on this journey together!

What is the Weighted Average Method (WHAM)?

The Weighted Average Method (WHAM) is an inventory valuation method that calculates the average cost of inventory over a specific period. Unlike FIFO or LIFO, which rely on the chronological order of inventory purchases, WHAM assigns the average cost of production to a product, resulting in a cost that represents a midpoint valuation. The method is commonly used in accounting and is permitted under both GAAP and IFRS accounting. The formula for the weighted average cost method is to divide the cost of goods available for sale by the number of units available for sale. The result of using the weighted average cost method is that the recorded amount of on-hand inventory will represent a value somewhere between the oldest and most recent stock units purchased. The method is helpful for businesses that have inventory prices that vary widely, but it may not recover the costs of the more expensive units and may even result in a loss. The weighted average cost method simplifies accounting by revealing the average cost of each piece, which saves time and keeps bookkeeping headaches at bay.

How is WHAM Different?

The Weighted Average Method (WHAM) is different from other inventory valuation methods in the following ways:

- WHAM calculates the average cost of inventory over a specific period, whereas FIFO and LIFO rely on the chronological order of inventory purchases[1][4].

- WHAM assigns the average cost of production to a product, resulting in a cost that represents a midpoint valuation[4].

- WHAM is suitable for a wide range of businesses, but it finds its predominant usage among manufacturing companies[2].

To arrive at a singular, averaged cost price using WHAM, all the purchase costs of an item are summed up, and the total is divided by the total quantity of the selected item. The method is helpful for businesses that have inventory prices that vary widely, but it may not recover the costs of the more expensive units and may even result in a loss. The weighted average cost method simplifies accounting by revealing the average cost of each piece, which saves time and keeps bookkeeping headaches at bay.

Which is better FIFO or weighted average?

FIFO and weighted average are two inventory valuation methods. FIFO stands for First in, First out, and it assumes that the oldest units of inventory are sold first. On the other hand, the weighted average method uses the average inventory levels to calculate inventory value. The main difference between the two methods is that FIFO is the most commonly used inventory valuation method, while the usage of the weighted average method is less compared to FIFO[2]. Companies that use FIFO regularly have updated prices in inventory and do not want outdated inventory[1]. Weighted average is a simple and consistent method that smooths out the fluctuations in prices and avoids the extremes of FIFO and LIFO[3]. While FIFO method is easier to implement as it is easily understandable by the management of a company, the implementation of the weighted average method for inventory valuation is more tedious and time-consuming exercise[4]. Companies can decide which method to use based on their discretion[2].

Citations:

[1] https://www.investopedia.com/ask/answers/09/weighted-average-fifo-lilo-accounting.asp

[2] https://www.differencebetween.com/difference-between-fifo-and-vs-weighted-average/

[3] https://www.linkedin.com/advice/0/what-pros-cons-using-fifo-lifo-weighted-average-1c

[4] https://www.termscompared.com/difference-between-fifo-and-weighted-average-method-of-inventory-valuation/

[5] https://www.unleashedsoftware.com/blog/inventory-accounting-use-weighted-average-cost

[6] https://www.coursesidekick.com/accounting/317227

What are the advantages of the inventory weighted average method?

The inventory weighted average method is a commonly used inventory valuation method that offers many benefits, such as time savings and consistency. Here are some of the advantages of using WAC in your overall inventory management process:

1. Easily track inventory value: Unlike FIFO and LIFO that use a range of costs, the WAC method uses a blended average, making it easier to calculate and track inventory value. If you’re selling multiple SKUs of similar products, the WAC method is a great way to easily determine inventory value and maintain accurate financial statements[4][5].

2. Less paperwork for you: The WAC method requires a single cost calculation to determine the average value of all items in stock. Since every item is valued at the same amount, there is no need to maintain detailed inventory purchasing records, which means less paperwork to keep track of[4].

3. Cut overall costs: The cost of managing your inventory can cut into profits if you don’t take the time to optimize the process. Instead of counting up each sellable unit and then adding up the value of each product, the WAC formula provides a time-saving alternative to calculate current inventory value, which helps you save money in the long run. Furthermore, the WAC method particularly benefits high-volume companies or companies without much variation among their stock[6].

Other ways to simplify your process and reduce the costs associated with managing inventory are to use inventory management software and/or partner with a third-party logistics (3PL) company that provides inventory management tools, ecommerce warehousing, and real-time inventory reports. By optimizing your inventory management process and reorder quantity, you can reduce human error, spend less on labor, and save on inventory carrying costs[4].

Citations:

[1] https://www.investopedia.com/ask/answers/09/weighted-average-fifo-lilo-accounting.asp

[2] https://www.investopedia.com/terms/a/averagecostmethod.asp

[3] https://www.unleashedsoftware.com/blog/weighted-average-cost-method-inventory-valuation

[4] https://www.shipbob.com/blog/inventory-weighted-average/

[5] https://www.brahmin-solutions.com/learning-center/weighted-average-cost-method-inventory-valuation

[6] https://www.bluecart.com/blog/inventory-costing-methods

Case Study: Application in a Footwear Store

In the Footwear store example, the Weighted Average Method (WHAM) can be used to calculate the cost of goods sold for the first quarter. The following information is given:

- In January, 50 pairs of sneakers were purchased at $50 each.

- In February, 50 pairs were bought at $51 each, due to increased transportation costs.

- In March, raw materials were cheaper, resulting in the purchase of 100 pairs at $45 each.

- Throughout the first quarter, 120 pairs of sneakers were sold at a consistent price of cost of goods sold at $90 each.

To calculate the cost of goods sold using WHAM, the total cost of goods available for sale is divided by the total number of units available for sale. The calculation is as follows:

Total cost of goods available for sale = (50 x $50) + (50 x $51) + (100 x $45) = $5,950

Total number of units available for sale = 50 + 50 + 100 = 200

Weighted average cost per unit = Total cost of goods available for sale / Total number of units available for sale

= $5,950 / 200

= $29.75

Using the weighted average cost per unit of $29.75, the cost of goods sold for the first quarter can be calculated as follows:

Cost of goods sold = 120 x $29.75

= $3,570

Therefore, the cost of goods sold for the first quarter is $3,570. The weighted average method offers a nuanced approach to inventory valuation, especially for businesses dealing with fluctuating purchase prices.

Deriving the Weighted Average Price:

Before we can determine the inventory asset value, we need to first calculate the average purchase price.

If we merely average the prices (i.e., $50, $51, and $45), we get: (50 + 51 + 45) ÷ 3 = $48.66.

However, this regular average price doesn't truly reflect the distribution of items. That's why we turn to the weighted average price.

The weighted average price for the 200 pairs of sneakers (pre-sale) is:

[(50 pairs x $50) + (50 pairs x $51) + (100 pairs x $45)] ÷ 200 = ($2,500 + $2,550 + $4,500) ÷ 200 = $9,550 ÷ 200 = $47.75

Upon selling 120 pairs, the asset value of the items sold is: $47.75 x 120 = $5,730

The value of the remaining inventory is: 80 pairs x $47.75 = $3,820

Combining the asset values of the sold pairs with the remaining inventory: $5,730 + $3,820 = $9,550, providing an accurate total inventory asset value.

Conclusion

In conclusion, the Weighted Average Method (WHAM) is a nuanced approach to inventory valuation that calculates the average cost of inventory over a specific period. Unlike other inventory valuation methods, WHAM assigns the average cost of production to a product, resulting in a cost that represents a midpoint valuation. This method is suitable for a wide range of businesses, but it finds its predominant usage among manufacturing companies. WHAM is helpful for businesses that have inventory prices that vary widely, but it may not recover the costs of the more expensive units and may even result in a loss. The weighted average cost method simplifies accounting by revealing the average cost of each piece, which saves time and keeps bookkeeping headaches at bay. We hope this walkthrough has given you clearer insights into WHAM. Stay tuned for more inventory-centric knowledge in our upcoming videos. Cheers!

Citations:

[1] https://corporatefinanceinstitute.com/resources/accounting/weighted-average-cost-method/

[2] https://www.unleashedsoftware.com/blog/weighted-average-cost-method-inventory-valuation

[3] https://www.shipbob.com/au/blog/inventory-weighted-average/

[4] https://accountinginfocus.com/financial-accounting/inventory/weighted-average-inventory/

[5] https://www.shopify.com/retail/weighted-average-cost-method

[6] https://www.accountingtools.com/articles/weighted-average-method-weighted-average-costing

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What does Zoho Inventory do?

Zoho Inventory is a cloud-based inventory management software that helps businesses manage their inventory and shipping operations. It provides features such as product management, order management, shipping management, and reporting. Zoho Inventory helps businesses streamline their inventory operations and improve their overall efficiency and productivity.

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Zoho Inventory offers a free plan for businesses with basic needs. However, for businesses that require more advanced features and capabilities, Zoho Inventory also offers paid plans that provide additional features and support.

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