Fluctuating prices and complex calculations make it hard to accurately value inventory. Methods like weighted average cost (WAC) make it easy.
The WAC method smooths out price fluctuations over time by blending the costs of all units available for sale. This makes it easier to value inventory and establish a consistent cost basis, which streamlines accounting and improves your financial decisions.
Here’s how to use the weighted average inventory method to simplify accounting. Scroll to the end to learn how Fishbowl makes it easy to apply WAC — or any other inventory valuation method you choose.
Inventory WAC explained
WAC is an inventory valuation approach that averages the cost of all items available for sale in a given period. Instead of tracking individual costs of each unit, which can be cumbersome, WAC calculates a single average for a simplified cost of goods sold (COGS). This smooths out price fluctuations to provide a consistent value across inventory items, preventing extreme variations from impacting your reporting.
The WAC method is especially beneficial when inventory items are indistinguishable from one another, or when tracking individual item costs is impractical. Because of this, industries that produce large volumes of similar goods, like manufacturing and retail, often use it. WAC is also common when the price of goods fluctuates, as it prevents extreme valuations due to short-term price spikes.
WAC is an approved costing method under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), making it a reliable accounting choice for domestic and international businesses. It’s also beneficial for companies that prefer a fast, streamlined approach to inventory valuation.
How to calculate inventory WAC
Here’s how to calculate WAC for inventory accounting:
- Determine the total cost of goods available for sale: Add up the cost of all inventory items available for sale during the period, which can be a month, quarter, or year. Include beginning inventory and any purchases.
- Calculate the total number of units available for sale: Add up the number of units in your beginning inventory and any additional units you’ve purchased in the period.
- Get your WAC of goods sold: Divide the total cost of goods available for sale by the total number of units available for sale.
Plug the numbers you just found into the WAC method formula:
WAC = Total cost of goods available for sale / Total units available for sale
Here’s an example of this method in practice. Imagine your company starts the period with 100 units of inventory that cost $1,000 in total. During the period, you purchase another 200 units at a total cost of $3,000.
The total cost of goods available for sale is $4,000 ($1,000 from beginning inventory plus $3,000 in purchases). The total number of units available for sale is 300 (100 units from beginning inventory plus 200 units purchased).
Using the WAC formula, you’d divide 4,000 by 300 to get $13.33 per unit at the end of the period.
3 benefits of the WAC method
Here are three practical benefits of using the WAC method.
1. Simplicity and speed
WAC averages the cost of all units available, eliminating the need to track individual costs for each inventory item. This simplified tracking means businesses can streamline their accounting processes and reduce administrative burdens, freeing up energy and resources better applied to strategic growth and operational tasks.
2. Price stability
By averaging the costs of all inventory units, WAC dampens the effects of market volatility, leading to more stable and predictable financial statements. This offers a more accurate picture of your overall cost structure — which is vital for prudent financial decisions. Stable and predictable cost data lets you better manage pricing strategies and control expenses.
Consistent cost allocation also eliminates one-off cost distortions, making it easier to compare financial performance across different periods. That consistency helps you track trends, assess strategy impact, and manage resources with greater confidence.
3. Compliance
With WAC, you can rest assured that your inventory valuation practices are compliant with GAAP and IFRS. Complying with accounting standards reduces the risk of discrepancies during audits and enhances your financial reports’ credibility. Investors, creditors, and other stakeholders will have greater confidence in your numbers, facilitating better relationships and more informed decision-making.
4 alternatives to WAC for valuation
WAC can streamline inventory valuation, but it may not work for companies that require more nuance in their reporting. If it won’t meet your needs, here are four alternative methods to explore.
1. First-in, first-out (FIFO)
The FIFO method assumes that the oldest inventory items are the first to sell, so you use the cost of the oldest units to calculate COGS. This is the formula:
COGS = Cost of oldest goods x Number of goods sold
There are two main reasons to adopt the FIFO method. First, FIFO reflects some businesses’ actual inventory management practices. Many companies sell their oldest inventory items first because those items are perishable or subject to obsolescence. And second, the FIFO method can elevate reported profits. Older inventory items often cost less than new items due to factors like inflation, so FIFO typically results in a lower COGS, which boosts profit margins.
2. Last-in, first-out (LIFO)
The LIFO method is the opposite of FIFO. It assumes that the most recently acquired inventory items are the first to be sold. Here’s the LIFO method formula:
COGS = Cost of newest goods x Number of goods sold
Since newer items tend to be more expensive due to inflation, LIFO usually reduces COGS and therefore your reported profits. This is advantageous when you want to save on taxes, improve cash flow, or optimize accounting during periods of rising prices.
As with FIFO, you can use LIFO for inventory accounting regardless of how you move inventory. But it’s important to note that LIFO is only accepted in the U.S. GAAP allows it, but IFRS doesn’t, which makes it unsuitable for businesses operating abroad.
3. Specific identification
The specific identification method tracks inventory costs item by item — ideal for businesses dealing in unique or high-value items, like automobiles or jewelry, where each unit has a distinct cost. Since it requires detailed tracking, this method is usually impractical for businesses with large volumes of similar inventory items.
4. Standard costing
With standard costing, you assign costs to production factors like labor and materials before adding them up to determine a standard cost for each inventory item. Later, you compare this number to actual costs to assess your financial performance. Because the costs vary so much, there’s no standard formula for this method.
Standard costing may not reflect actual expenses, which could lead to accounting discrepancies — but it can be useful for manufacturing businesses whose costs are relatively stable and predictable.
Simplify your inventory management with Fishbowl
Choosing a valuation method is an important business decision, so don’t take it lightly. If you’re unsure, consult with an accountant and do your research. And when you’re ready to commit to a costing method, Fishbowl has you covered.
Fishbowl’s software seamlessly integrates with QuickBooks, making it easy to apply the costing method of your choice. See the difference Fishbowl can make in your inventory management today.