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When the number of SKUs in your inventory exceeds a certain limit, the variation in their pricing becomes enormous. The average value for this stock is manipulated heavily as the items with higher value create distortion. This, in turn, creates problems for inventory control, procurement, and sales. In this article, we will discuss the need to use WAC, its formula, and its application for online stores. Dive in deeper to learn more on the topic:
The formula for weighted average cost (WAC) method
In WAC, the cost of goods available for sale is divided by the number of products available for sale. Its formula is given by:
WAC per unit = Cost of Goods Sold ÷ Units available for sale.
The weighted average is used when the items to be counted are not easily distinguishable from each other. It is used when LIFO and FIFO are not applicable due to their complexity during application. It is used when other methods of assigning costs to individual items aren’t possible. This applies to both manual counting as well as barcode/ RFID tag-based counting systems. Both GAAP and IFRS accounting conventions approve using the WAC method. Weighted Average Cost (WAC) method estimates the amount distributed into inventory and the COGS through weighted average.
For inventory control, WAC is related to COGS calculation and is applicable to both periodic and perpetual inventory control systems. Using a weighted average cost method gives an amount in proximity to both older and latest purchases.
~ NRF Survey Report: The US alone suffered an inventory shrinkage worth $46.8 billion with an average shrink rate of 1.33%.
The simple average doesn’t consider the recency of an observation. In terms of business, recent consumer trends are far more relevant than the older ones. Also, some items are more important from the business point of view than others. It is similar to grading systems at the universities where some subjects are given higher weightage than others while calculating a cumulative average. This allows the firm to make better purchase decisions and responsively align their operations.
Example of applying weighted average cost (WAC) method for inventory control
In the below example, a company starts the month with 220 nos. of an item on the 1st of August, 2020, and it records the following sale and purchase (stock replenishment) figures.
|Quantity Change||Actual Unit Cost||Actual Total Cost|
|Beginning Inventory (1st Aug)||220||40||8800|
|Ending Inventory (31st Aug)||60|
The following observations explain how WAC impacts inventory control:
- The actual total cost for the inventory is $16,650 ($8800 worth of beginning inventory + $7,850 worth of purchased subsequently)
- The total inventory units are 410 nos with a beginning stock of 220 nos and 190 nos purchased later.
- The weighted average cost per unit is is $16,650/ 410 nos = $40.6
- The inventory valuation at the end is 60 units x 40.6 WAC = $2436.
- The COGS is $14,210 (350 nos. x 40.6 WAC.)
- Both of these amounts total to $16,646, which is nearly equal to $16650 (the actual cost of beginning inventory and subsequent purchases) when rounded off.
Advantages of using weighted average cost (WAC) method
Without the weighted average cost method, you wouldn’t be able to manage inventory without assigning different costs to your incoming and stored inventory. WAC allows you to store your inventory without assigning separate costs to all identical items. Thus, your inventory management process becomes very simple and doesn’t require you to keep a tab of the pricing for all purchases.
It makes inventory evaluation easier and requires lesser documentation. This makes WAC more friendly as compared to LIFO and FIFO. The simplification of the process also means that it will require lesser workforce hours to manage your inventory.
Disadvantages of using weighted average cost (WAC) method
As discussed earlier, you cannot use this method for items with very high price variations or completely dissimilar in nature. If they are commodities controlled by very different factors, using WAC isn’t a good choice in this case either. While this method is completely fine with goods like fuels and food items, applying it for mass production items can be tricky if your OEM/supplier upgrades or changes the product.
You need to conclude the accounting process within the same accounting period i.e., COGS for an accounting period is reported against the revenue of the same period. The total costs remain the same in both perpetual and periodic inventory systems. Using WAC enables businesses to measure the prices for every batch procured against specific pricing. Thus, the Weighted Average Method (WAC) is the ideal choice for online retailers, dropshippers, and other firms that deal in large volumes of identical products with a healthy inventory turnover ratio.
Neel is a creative who's always ready to lay his hands on anything that is innovative and captures masses. He is currently working with Orderhive. Apart from technology and business practices, he drools over psychology, history, and cinematography. You can find him on hiking trips, talking over anything from alien belief systems to 90's cartoon shows.
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