Accounting for Inventories

7.1.4 Weighted-average cost flow method

The weighted-average method (also called the average cost method) provides that the average unit cost is included in the cost of goods sold.

Weighted-average (average cost) inventory costing method assumes that the average cost of inventories is to be recognized as the cost of goods sold.

In order to determine the weighted-average, you need to add all the costs of the items on hand and divide the result by the number of items. In our example, the calculation is as follows: ($5,000 + $5,500) / 2 = $5,250. This amount will be charged to the cost of goods sold when an item is sold.

It is important to note that the methods described above only refer to cost flows of inventory, and usually not to their physical flows. Physical inventory flows usually follow the specific identification or FIFO rules.

7.1.5 Effects of different cost flow methods on the income statement

A selected cost flow method has a direct effect on the cost of goods sold and gross margin numbers. Look at the table below and compare the same dealership's gross margins determined using different cost flow methods. Assume that sales are $8,000 and only one car was sold.

Illustration 7.1: Effect of cost flow methods on gross margin

	FIFO	LIFO	Weighted - Average
Sales	$8,000	$8,000	$8,000
Cost of Goods Sold	($5,000)	($5,500)	($5,250)
Gross Margin	$3,000	$2,500	$2,750

Inventory costs are allocated between the cost of goods sold and the ending inventory at period end. Therefore, the cost flow method selected by a company also affects the balance sheet numbers. FIFO transfers the first costs to the income statement leaving the last in the balance sheet. Contrary, LIFO moves the first cost to the income statement and retains the last cost in the balance sheet. The weighted-average uses the same average costs for both income statement and balance sheet. Look at the table below to see the balance sheet ending inventory numbers under the three cost flow methods (the same example):

Illustration 7.2: Effect of cost flow methods on ending inventory balances

	FIFO	LIFO	Weighted- Average
Beginning Inventory	$10,500	$10,500	$10,500
Cost of Goods Sold	($5,000)	($5,500)	($5,250)
Ending Inventory	$5,500	$5,000	$5,250

7.2 Application of different cost flow methods

So far we have been talking about two inventory layers with one inventory item (a Ford) in each. In real life companies deal with multiple inventory layers. In addition, companies can choose between inventory cost flow methods using either perpetual or periodic system. Combinations of the cost flow methods and systems result in different numbers in the income statement and balance sheet. The following examples will give you a better understanding of inventory cost allocation concepts.

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