Hey there, my name's James and I'm going to explain how the
weighted average cost method works in four simple steps.
[Music]
So the weighted average cost method
is a bit of a mouthful… which is why sometimes you might hear it shortened
to WAVCO, or the average cost method or just plain AVCO…
that's the one I like.
It can all seem a bit confusing but just remember that all of these
terms mean the same thing.
They describe an inventory cost flow assumption.
What does that mean?
How does that work?
Let's find out.
It all comes down to the inventory calculation.
You're opening inventory plus your additions gives you your cost of goods available for sale
and when you take away your
cost of goods sold from it you get your closing inventory.
Remember when I say inventory I mean the goods held by your business
that you intend to sell to earn revenue.
The thing is when you make a sale you don't only earn revenue
you also incur a cost and inventory costs flow assumptions
help you estimate or that cost should be.
There are three inventory cost flow assumptions FIFO, LIFO and AVCO.
First In First Out, Last In First Out and the average cost
or weighted average cost method.
When you make a sale using AVCO you assume that all of your
goods available for sale are valued at their weighted average cost per unit.
It doesn't matter what order you bought your inventory.
You assume that it all gets mixed up together whether or not that's the case in reality.
Remember this is an assumption.
You can work out your weighted average cost per unit by taking your
total cost of goods available for sale and dividing it by your
quantity of goods available for sale.
Don't worry we'll come back to this equation soon but first
I'd like to give it some context.
Let's imagine that you work in wholesale in the window cleaning industry
buying and selling squeegees.
It's the beginning of November and you have an opening inventory of 220 squeegees
which each cost you $2 per unit.
On November 5th you go buy another 400 more squeegees for $1,200 in total
and on November 12th you manage to sell 500 squeegees for $2,750.
The question is… what’s your cost of goods sold
and closing inventory for November assuming that you're using the
weighted average cost method to value your inventory.
It's time for that four-step process.
Step 1.
Draw an inventory cost flow table.
What's that?
It's a table with five columns.
Date, description, quantity, cost per unit and total cost.
Step 2 Enter what you know.
Hmm… okay.
Well, we know that you started November with 220 squeegees
which cost you $2 each.
So at the start of November you had an opening inventory of 220 units
which cost you $2 per unit.
A few days later on November 5th you purchased another 400 squeegees
for a total cost of $1,200.
We'll need to pop this in the table too.
On November 5th you made additions of 400 units which cost you a total of $1,200.
In inventory costs flow tables it's important to leave a blank row
under each addition or sale.
This gives you some space to calculate your goods available for sale.
Finally on November 12th you sold 500 squeegees and earned
$2,750 in revenue.
Now be careful here.
This is the revenue that you've earned not the cost of goods sold that you incurred.
So this doesn't have a place in the inventory cost flow table.
That means on November 12th you sold 500 units but we don't know
your total cost of goods sold yet.
We'll work this out along with your closing inventory on November 30th.
Time for Step 3.
Fill in the blanks.
We'll start by working out the total cost of your opening inventory.
You began the month with 220 units which cost you two dollars per unit.
220 multiplied by $2 is $440.
Next we need to find the cost per unit of your additions.
You bought 400 units which cost you $1,200 in total.
$1,200 divided by 400 units is $3 per unit.
To work out your goods available for sale we'll need to take some subtotals.
220 plus 400 is 620 units available for sale and 440 plus 1200 is $1640.
Your total cost of goods available for sale.
Okay here's where the AVCO equation comes in.
We need to work out the weighted average cost per unit
of your goods available for sale.
This is your total cost of goods available for sale
divided by your quantity of goods available for sale.
Right so your total cost of goods available for sale is $1,640
and your quantity of goods available for sale is 620 units.
1640 divided by 620 is 2.64516129
Brrhhh…
but we'll round this to $2.65 per unit.
$2.65 the weighted average cost per unit of your goods available for sale.
Alright keep this number in mind for the next bit.
We'll be using it to work out your total cost of goods sold.
Your total cost of goods sold is your quantity of goods sold multiplied by
the weighted average cost per unit of goods sold.
We already know that you sold 500 units but what's your weighted average cost per
unit of goods sold?
It's exactly the same as the weighted average cost per unit
of your goods available for sale.
$2.65 per unit.
So 500 units multiplied by $2.65 is $1,325.
Your total cost of goods sold.
Right now let's jump forward to the end of the month and work out
your closing inventory on November 30th.
How many units of inventory do you have left over?
Well 620 minus 500 gives you 120 units and the total cost of your closing inventory
is 1640 minus 1325 which is $315 of inventory on hand kept in your balance sheet.
Remember we rounded your cost per unit earlier on so this is an estimate.
Step 4.
Calculate your total cost of goods sold and your closing inventory.
Your total cost of goods sold for the month can be calculated by adding up your
cost of goods sold for every sale that you've made.
In this problem that was only one sale so your total cost of goods sold
for November is $1,325 and you can find the total cost of your closing inventory down here
in the bottom right corner…
$315.
Okay now I'd like to show you something interesting.
This inventory cost flow table mirrors the inventory calculation
that we had up at the start of the video.
Neat hey?
But what are the implications of using the weighted average cost method?
AVCO matches your current revenues against your average cost of goods.
It's like the middle ground between the First In First Out and Last In First Out methods.
What do I mean by that?
Well FIFO matches your current revenues against your older cost of goods
whereas LIFO matches your current revenues against your most recent cost of goods.
AVCO falls somewhere in the middle it uses a weighted average.
So for example during times of inflation where cost prices are rising
your cost of goods sold under LIFO tend to come out the highest because it
reflects your most recent purchases and your cost of goods sold under FIFO
would come out the lowest because this assumes that you're selling off your
older, cheaper inventory first.
With the average cost method your results come out somewhere in the middle.
If you'd like to see how I calculated these results
using FIFO or LIFO then you can find the videos In the inventory playlist over here.
I've summarized all four steps that we just went through in my cheat sheet
you can help support the channel by buying it on my website.
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