Weighted-Average Cost Flow Assumption

The weighted-average cost flow assumption is a method of assigning costs to inventory and to cost of goods sold when identical items have been bought at different prices. Instead of tracking which specific units were sold, the business calculates an average cost per unit for all goods available, weighted by the quantity bought at each price, and applies that average to both the units sold and the units remaining. It is often referred to simply as the average cost of inventory method.

It is one of the main cost flow assumptions, alongside first in, first out (FIFO) and last in, first out (LIFO). It suits businesses whose goods are interchangeable and mixed together, such as fuel in a tank, grain in a silo or bulk chemicals, where it would be impractical to identify which delivery each sale came from. It is permitted under both US GAAP and IFRS; IFRS allows only weighted average and FIFO, not LIFO.

Under a periodic inventory system, one average is calculated at the end of the period:

Here $\text{Cost of goods available for sale}$ is beginning inventory plus purchases during the period, in dollars, and $\text{Units available for sale}$ is the corresponding number of units. The cost of goods available for sale is then split between ending inventory and cost of goods sold using that unit cost.

A building supplier's records for bags of cement show:

During the period, 6,500 bags are sold. The weighted-average cost is $69,200 divided by 8,000, or $8.65 per bag. Cost of goods sold is 6,500 times $8.65, or $56,225, and ending inventory is 1,500 times $8.65, or $12,975. The two add back to $69,200.

For comparison, FIFO would charge the oldest costs first, giving cost of goods sold of $55,700 and ending inventory of $13,500, while periodic LIFO would charge the newest costs first, giving cost of goods sold of $57,000 and ending inventory of $12,200. With rising prices, the weighted average falls between the two.

Under a perpetual inventory system, a new average is calculated after each purchase, known as the moving average method. Each sale is costed at the average in effect at the time. If the supplier sold 2,500 bags in March, after the February purchase, those would be costed at the average of the first 4,000 bags, $33,200 divided by 4,000, or $8.30. After the May purchase, a new average would be calculated using the remaining units and the new delivery. Results usually differ slightly from the periodic method.

The weighted-average method is simple, smooths the effect of price swings on reported margins, and is hard to manipulate by timing purchases. It reflects the physical reality of commingled goods. However, during periods of steadily rising prices it reports inventory below current cost and profits below FIFO, though above LIFO, and it does not provide the tax deferral that LIFO offers in the United States. Whichever method is chosen must be applied consistently and disclosed in the notes as part of inventory valuation policy, and inventory measured at weighted average is still subject to the lower of cost or net realizable value test.