The weighted average cost (WAC) method is an accounting strategy retailers use to calculate the average purchase price of each unit of their inventory. Why can’t retailers just refer to the price they paid vendors? Because prices fluctuate, and as they purchase additional batches of inventory, it becomes difficult to keep track of which item cost exactly how much.
Businesses typically use the weighted average cost method alongside or as an alternative to the First In, First Out (FIFO) and Last In, First Out (FIFO) accounting methods.
What is the weighted average cost (WAC) method?
The weighted average cost method calculates the average cost of your inventory, per unit. You can calculate WAC by dividing your cost of goods sold (COGS) by the total number of units in your inventory.
Dr. Saibal Ray, James McGill Professor and Academic Director at McGill University’s Bensadoun School of Retail Management in the Desautels Faculty of Management, says it’s called the weighted average cost method because the metric is based on the volume of units purchased.
WAC can help retailers understand how much each item in their inventory costs to purchase (or produce) without doing complicated calculations.
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Weighted average vs FIFO vs LIFO
The weighted average cost method is just one strategy for valuing your inventory. FIFO and LIFO are other costing methods that are typically used alongside the weighted average. Each strategy has its own best-use cases.
As noted, the weighted average cost method divides COGS by the total number of units in the inventory. It’s best to use when it’s too logistically complicated to distinguish each individual unit of inventory and know how much you paid for it.
When you have a lot of inventory on hand and you do not know the order in which you are selling it, you are mixing all of your units. The weighted average cost method gives you an overall idea about the inventory you have on hand and how much it costs.
Dr. Ray continues, “This model is a good thing from a managerial viewpoint, because it is easier to understand how much your inventory costs on average [than with a more precise accounting method]. But, from a pure accounting viewpoint, this method is a bit problematic, because you do not know what you bought at what price.”
When the weighted average cost method is no longer useful, that’s when other accounting methods, like FIFO and LIFO, come in handy.
The First In, First Out (FIFO) method assumes that customers are buying the oldest pieces of inventory in stock. FIFO uses the COGS for the items that were purchased first and divides it by the number of units purchased. Therefore, the cost of the oldest items is reported in the company’s financial statements.
Dr. Ray warns that using the FIFO method can inflate your profit margins, which can result in a higher tax burden for your business.
“Today, in a very high-inflation environment, the inventory that you bought in the last month is quite expensive, but the inventory that you bought two years back is not that expensive. If you are selling today at a high price, but you are selling products which you bought two years back, that means your profit margins will be quite high, especially if you are using FIFO, and that means your taxes will be high,” he says.
However, he also points out that FIFO is the most equitable accounting method.
FIFO is perhaps the most fair method, but with FIFO you have to keep track of exactly when you bought the product and exactly when it’s being sold. So, if you have a very good IT system, then perhaps FIFO is perhaps the most natural way to think about accounting. If you do not have a very good IT system, then either weighted average cost method or LIFO will do
The Last In, First Out (LIFO) method assumes that customers are buying the newest items in your inventory. Therefore, costs are calculated by dividing the COGS of the newest items in your inventory divided by the number of units purchased. The cost of the newest items are thus reported in financial statements.
From a government perspective, LIFO is the worst in a high-inflation environment, because today my price is high, but I will report that the last thing that I bought is what I am selling today. So, my margins will be small and my tax burden will be small.
Dr. Ray explains, “With LIFO and FIFO there is always a way of manipulating things to minimize taxes. Though to be fair, the companies have to declare the method they are using; if the government sees that they are continuously changing their method from LIFO to FIFO and FIFO to LIFO, then they will know that they are trying to manipulate the system. But, if you are using one particular method throughout, sometimes you will have an advantage and sometimes you will have a disadvantage. Over the long term, though, things will balance out.”
How to calculate weighted average cost
The average weighted cost method simplifies accounting. We’re sharing the formula for this accounting strategy and walking you through a sample calculation.
Weighted average cost per unit formula
The formula for weighted average cost per unit is:
Weighted Average Cost Per Unit = Cost of Goods Sold/Number of Units Bought
To find your cost of goods sold, add up how much it cost you to buy all of your inventory over multiple purchases.
The number of units is the total number of units you purchased over the same period.
Example of the weighted average cost method
Dr. Ray will take us through a sample WAC calculation.
“Let’s say Best Buy is buying televisions from Samsung to sell to the customers, but they are not buying all the televisions at the same time. They are buying televisions in batches. And all of them are not sold at the same time.”
“Let’s say they bought 100 units at $600 per piece, one year ago, another 100 units at $650 per piece three months back, and they now buy 100 units at $700 per piece. Let’s say they have not sold anything. So, now in their stock, they have 300 televisions.”
Unlike FIFO and LIFO, Dr. Ray explains, “The average cost method doesn’t keep track of these different costs. Instead, Best Buy would multiply 100 units by $600. That is how much they paid for the first 100 televisions.”
COGS for 1st batch=100*$600=$60,000
“Then they would multiply 100 units by $650, which is what they paid for the second batch,” he says.
COGS for 2nd batch=100*$650=$65,000
“Then they would multiply 100 units by $700, and that’s what they paid for the third batch,” he says.
COGS for 3rd batch=100*$700=$70,000
“So the WAC would be the total they paid divided by 300 units,” Dr. Ray explains.
Therefore, the weighted average cost of these televisions is $650 per unit.
Benefits of the weighted average costing method
- Track inventory value
- Less record-keeping
- Save money
There are several reasons why knowing your weighted average cost per unit is helpful.
Track inventory value
The weighted average cost method makes it easy to understand the value of your inventory. Prices fluctuate, so it can be difficult to know exactly how much you paid for each individual unit. The WAC method simplifies accounting by revealing the average cost of each piece.
When you use the weighted average method, you don’t have to be precise about which items were bought when, and how much they cost. This simplicity saves your finance team time and keeps bookkeeping headaches at bay.
When you have to keep less detailed records about how much each item cost and when it was sold, you save time. And when you save time, you can also save money by needing less help on the administrative side of your business.
Disadvantages of weighted average costing
- Doesn’t account for new versions of products
- Not ideal for inventory with wide price ranges
WAC isn’t the best accounting method to use in every scenario, which is why the FIFO and LIFO accounting methods exist. These are a few of the shortcomings of weighted average costing.
Doesn’t account for new versions of products
Because you’re looking at the average cost of your products, and not the latest costs of the newest products, WAC doesn’t account for the actual price of your newest inventory, which may be significantly more expensive than older inventory during periods of high inflation.
When there’s high inflation, there is also high price volatility.
Dr. Ray continues, “And when price volatility is high, which accounting method you use really matters. When there is not much price volatility in the market, or when inflation is not a problem, your accounting method doesn’t matter that much. It still matters, but not as much.”
Not ideal for inventory with wide price ranges
Weighted average costing doesn’t work as well when you’re dealing with inventory that’s experienced great price fluctuations. Other accounting methods are better to use when there’s a supply chain flux in which prices may vary greatly.
Is the WAC method right for your store?
Sky-high inflation and supply chain interruptions are making inventory costs change like never before. The weighted average cost per unit accounting method can help you keep track of costs, which can impact your prices and save you time and money on administrative tasks. Use it in conjunction with the FIFO and LIFO accounting methods as you operate your store to have a better understanding of your business and drive decisions.
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