Inventory Valuation - Weighted Average Cost

Body

Overview

Accounting Seed has implemented a weighted-average cost methodology for all new implementations of its Orders & Inventory module, replacing the standard unit cost methodology supported in our earlier releases.

Note: Organizations that have already installed Accounting Seed prior to its Hibiscus Fall 2019 release have been grandfathered though it is highly encouraged that they migrate to the new weighted-average cost methodology. Please contact Support to develop a plan to migrate to weighted-average cost.

Background
Why Move to Perpetual Average Cost Method
Perpetual Average Cost Method
Summary

Background

There are a number of different cost flow methods available for Inventory / Cost of Goods Sold (COGS) valuations. Perpetual systems continuously update the inventory, avoiding issues inherent with periodic based systems. For cost flow, there are three (3) accepted cost methodologies: FIFO, LIFO, and Weighted-Average Cost (also commonly referred to as Average Cost).

FIFO or First-In, First-Out, always assigns the cost of the earliest unit available at the time of sale to COGS, regardless of which unit from the inventory pool is used.
LIFO or Last-In, First-Out, always assigns the cost of the newest unit available at the time of sale to COGS, regardless of which unit from the inventory pool is used.
Average Cost calculates the cost that is assigned to COGS and inventory each time new units are purchased and added to the inventory.
*This method is supported by Accounting Seed standard functionality.

The graphic below illustrates these 3 methods.

Return to top

Why Move to Perpetual Average Cost Method

Perpetual Average Cost method is widely accepted by numerous accounting standards, including US GAAP and IFRS. It is, at its most simplistic, just an average. Using an average significantly simplifies the calculations and recordkeeping associated with maintaining the inventory and determining the Cost of Goods Sold. Both FIFO and LIFO require that individual items be tracked, which can be expensive. When there are large volumes of items, Average Cost is superior to FIFO and LIFO, especially when the items are indistinguishable from one another or when tracking individual items would be highly inefficient. Average Cost can also effectively normalize cost fluctuations and volatilities and help reduce the inappropriate manipulation of income.

Return to top

Perpetual Average Cost Method

Perpetual Average Cost, aka Moving Average Cost, calculates a new average unit cost for the inventory after each purchase of new units. To be more specific, the recalculation should occur when the items are “received” and are available. (Note: Care should be taken when determining if an item should be deemed as received as it can be impacted by the shipping terms.) The new average cost is then used to value the inventory and Cost of Goods Sold until the next purchase of new units is received. At that time, the average cost is recalculated and this new average cost is used.

The average cost formula is:

Screen_Shot_2019-09-20_at_2.13.12_PM.png

A sale of inventory does not impact the average cost and does not trigger a recalculation. When inventory is allocated to the sales order, the quantity available for sale is reduced and the Cost of Goods Sold / Inventory GL transactions associated with a Billing are recorded. This transaction uses the current Average Cost assigned to the inventory at that time.

Note: With the Hibiscus Fall 2019 release, the Cost of Goods Sold / Inventory GL transactions associated with a Billing are recorded on the Sales Order Inventory Movement for all customers using Accounting Seed’s Weighted-Average Cost Inventory feature.

The Billing creates and posts the GL transactions debiting Accounts Receivable and crediting Product Revenue. Allocation of the Sales Order creates the Sales Order Inventory Movement which creates and posts the GL transactions debiting Cost of Goods Sold and crediting Inventory. Users should ensure that the Sales Order Inventory Movement and Billing occur within the same period so as to not violate matching principles.

The following example illustrates when and how the Average cost is calculated.

From the example above, each time there is a purchase that adds additional units into Inventory, the average cost is recalculated. This weighted-average ensures that both past and new purchases are incorporated into the cost, ensuring that Costs of Goods Sold is not overstated (which is an issue with LIFO) or understated (which is an issue with FIFO).

The next example shows the accounting transactions and how the Average Cost is used.

Finally, how these transactions flow into the income statement and balance sheet.

Create_Sales_Order_2.0.png

Return to top

Summary

Average Cost methodology calculates a weighted-average cost each time a purchase adds units to available inventory. Utilizing a weighted-average cost ensures that the Cost of Goods Sold is not skewed higher, as it is with LIFO, or lower, as it is with FIFO. It reduces the need to track individual units and simplifies the inventory process.

Note: Organizations that have already installed Accounting Seed prior to its Hibiscus Fall 2019 release implemented standard cost have been grandfathered though it is highly encouraged that they migrate to the new weighted-average cost methodology. (Note: Please contact Support to develop a plan to migrate to weighted-average cost.)

Return to top

Title

Inventory Valuation - Weighted Average Cost

URL Name

1353878503