5.5 Weighted Average Method
The Weighted Average Method¶
The weighted average method calculates a new average cost each time a purchase is made. This average cost is then used to value subsequent issues (sales or material consumption).
Example: Perpetual Inventory with Weighted Average¶
Using the same purchase data:
- Jan 1: 500 units @ ₹200
- Feb 1: 600 units @ ₹230
- Mar 1: 800 units @ ₹210
- Apr 1: 1000 units @ ₹180
- May 1: 700 units @ ₹220
- Jun 1: 400 units @ ₹250
Here's the perpetual inventory calculation using the weighted average method:
| Date | Transaction | Units | Rate (₹) | Value (₹) | Balance Units | Weighted Avg. Rate (₹) | Balance Value (₹) |
|---|---|---|---|---|---|---|---|
| Jan 1 | Purchase | 500 | 200 | 100,000 | 500 | 200 | 100,000 |
| Jan 15 | Issue | 400 | 200 | 80,000 | 100 | 200 | 20,000 |
| Feb 1 | Purchase | 600 | 230 | 138,000 | 700 | (20,000+138,000)/700 = 225.71 | 157,997 ≈ 158,000 |
| Feb 15 | Issue | 500 | 225.71 | 112,855 | 200 | 225.71 | 45,142 ≈ 45,140 |
| Mar 1 | Purchase | 800 | 210 | 168,000 | 1000 | (45,140+168,000)/1000 = 213.14 | 213,140 |
| Mar 15 | Issue | 900 | 213.14 | 191,826 | 100 | 213.14 | 21,314 |
| Apr 1 | Purchase | 1000 | 180 | 180,000 | 1100 | (21,314+180,000)/1100 = 183.01 | 201,314 ≈ 201,310 |
| Apr 15 | Issue | 800 | 183.01 | 146,408 | 300 | 183.01 | 54,903 ≈ 54,900 |
| May 1 | Purchase | 700 | 220 | 154,000 | 1000 | (54,900+154,000)/1000 = 208.90 | 208,900 |
| May 15 | Issue | 500 | 208.90 | 104,450 | 500 | 208.90 | 104,450 |
| Jun 1 | Purchase | 400 | 250 | 100,000 | 900 | (104,450+100,000)/900 = 227.17 | 204,450 ≈ 204,450 |
| Jun 15 | Issue | 600 | 227.17 | 136,302 | 300 | 227.17 | 68,151 ≈ 68,150 |
Summary:
- Total Purchases: ₹840,000
- Total Issues (Material Consumption): ₹771,841 ≈ ₹771,850
- Ending Inventory Value: ₹68,151 ≈ ₹68,150
Comparison of Methods¶
| Method | Consumption Value (₹) | Ending Inventory Value (₹) |
|---|---|---|
| FIFO | 765,000 | 75,000 |
| LIFO | 784,000 | 56,000 |
| Weighted Average | 771,850 | 68,150 |
As you can see, the weighted average method produces results that fall between FIFO and LIFO.
Tax Implications¶
The weighted average method has a moderate effect on taxes compared to FIFO and LIFO. It doesn't provide the same tax advantages as LIFO in rising price environments (in the U.S.) or the same tax disadvantage as FIFO in those environments.
Practical Considerations¶
In computerized systems, calculating the weighted average is straightforward. This makes it a practical choice for many businesses. Unlike LIFO, it doesn't create layers of inventory at different costs, simplifying record-keeping. The periodic averaging of LIFO values is a mitigation strategy to address this LIFO layering problem.
Consistency¶
Once a company chooses an inventory valuation method, it should consistently use that method in subsequent periods, as per the consistency principle in accounting.
In summary, the weighted average method is a practical and widely used approach that offers a balance between simplicity and accuracy. It's particularly suitable for businesses with large volumes of similar items where tracking individual costs is impractical.
Inventory and concepts¶
The Conservatism Concept and Lower cost or market(LCM)¶
The conservatism concept in accounting dictates that when choosing between two acceptable accounting methods or values, the method or value that results in lower net income and/or lower asset valuation should be selected. This principle is applied in inventory valuation through the lower of cost or market (LCM) rule.
The LCM rule states that inventory should be valued at the lower of its historical cost or its current market value. This prevents overstating the value of inventory on the balance sheet.
Net Realizable Value (NRV)¶
When a market value is not readily available (e.g., for work-in-progress), the net realizable value (NRV) is used as the "market" value for comparison with cost.
NRV is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
Formula: NRV = Estimated Selling Price - Estimated Costs of Completion - Estimated Costs of Disposal
Example: Work-in-Progress Inventory¶
Suppose a company has work-in-progress (WIP) inventory with the following information:
- Cost of WIP: ₹20,000
- Estimated costs to complete: ₹10,000
- Estimated selling price (once completed): ₹28,000
Calculating Net Realizable Value¶
NRV = ₹28,000 (Selling Price) - ₹10,000 (Costs to Complete) = ₹18,000
Applying the LCM Rule¶
Now, compare the cost (₹20,000) with the NRV (₹18,000). According to the LCM rule, the inventory should be valued at the lower of the two:
- Cost: ₹20,000
- NRV: ₹18,000
Therefore, the work-in-progress inventory will be recognized at ₹18,000. This results in a loss of ₹2,000 (₹20,000 - ₹18,000), which is recognized in the current period.
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