The average cost inventory method is an accounting technique used to calculate the cost of goods sold and ending inventory. The idea behind it is to assign a weighted average unit cost to the cost of a product.
The formula of weighted average unit cost can be expressed as follows:
Weighted Average Unit Cost = | Inventory’s Total Cost |
Total Units |
XYZ Ltd has made following transactions during the first quarter:
Let’s compute the ending inventory on 31st of March and cost of goods sold using the weighted average cost inventory method.
In the periodic inventory system, the inventory balance is updated once at the end of the accounting period. Thus, we should find the weighted average unit cost first.
Total units available for sale = 45,000 + 75,000 + 90,000 + 60,000 = 270,000 units
Inventory’s total cost = 45,000 × $150 + 75,000 × $165 + 90,000 × $175 + 60,000 × $170 = $45,075,000
Weighted average unit cost = $45,075,000 ÷ 270,000 = $164.94
Second, we should compute the number of units sold to find the ending inventory.
Units sold = 23,000 + 27,000 + 35,000 + 65,000 + 35,000 + 42,000 = 227,000 units
Ending inventory = 270,000 – 227,000 = 43,000 units
Ending inventory cost = 43,000 × $166.94 = $7,178,611.11
Please note that the cost of goods sold (COGS) is a balancing figure that is calculated as follows:
COGS = Beginning Inventory + Purchases - Ending Inventory
Beginning inventory = 45,000 × $150 = $6,750,000
Purchases = 75,000 × $165 + 90,000 × $175 + 60,000 × $170 = $38,325,000
COGS = $6,750,000 + $38,325,000 – $7,178,611.11 = $37,896,388.89
In the perpetual inventory system, the “Cost of Goods Sold” account and “Inventory” account are updated each time a transaction is made.
Jan 1
Inventory = 45,000 units
Inventory Account Balance = 45,000 × $150 = $6,750,000
Jan 10
Inventory = 45,000 + 75,000 = 120,000 units
Inventory Account Balance = $6,750,000 + 75,000 × $165 = $19,125,000
Weighted average unit cost = $19,125,000 ÷ 120,000 = $159.38
Jan 15
COGS = 23,000 × $159.38 = $3,665,625
Inventory = 120,000 – 23,000 = 97,000 units
Inventory Account Balance = $19,125,000 – $3,665,625 = $15,459,375
Jan 27
COGS = 27,000 × $159.38 = $4,303,125
Inventory = 97,000 – 27,000 = 70,000 units
Inventory Account Balance = $15,459,375 – $4,303,125 = $11,156,250
Feb 3
COGS = 35,000 × $159.38 = $5,778,125
Inventory = 70,000 – 35,000 = 35,000 units
Inventory Account Balance = $11,156,250 – $5,778,125 = $5,778,125
Feb 12
Inventory = 35,000 + 90,000 = 125,000 units
Inventory Account Balance = $5,778,125 + 90,000 × $175 = $21,238,125
Weighted average unit cost = $21,238,125 ÷ 125,000 = $170.63
Feb 21
COGS = 65,000 × $170.63 = $11,090,625
Inventory = 125,000 – 65,000 = 60,000 units
Inventory Account Balance = $21,238,125 – $11,090,625 = $10,237,500
Mar 4
Inventory = 60,000 + 60,000 = 120,000 units
Inventory Account Balance = $10,237,500 + 60,000 × $170.63 = $20,437,500
Weighted average unit cost = $20,437,500 ÷ 120,000 = $170.31
Mar 14
COGS = 35,000 × $170.31 = $5,960,937.5
Inventory = 120,000 – 35,000 = 85,000 units
Inventory Account Balance = $20,437,500 – $5,960,937.5 = $14,476,562.5
Mar 25
COGS = 42,000 × $170.31 = $7,153,125
Inventory = 85,000 – 42,000 = 43,000 units
Inventory Account Balance = $14,476,562.5 – $7,153,125 = $7,323,437.5
The total cost of goods sold amounted to $37,751,562.5, and the ending inventory is $7,323,437.5.
Please note that the cost of goods sold may differ in both the periodic and perpetual average cost inventory system!
The journal entries differ for the perpetual and periodic average cost inventory systems. Let’s assume that RetailPro Ltd has made following transactions during June:
The periodic inventory system assumes that all purchases of inventory during the accounting period are recorded in the “Purchases” account, which is updated after each transaction. The “Inventory” account is updated only once at the end of the accounting period. Let’s assume that all purchases and sales were made on credit. In that case, an accountant should make following journal entries:
Sale of inventory is recorded by debiting the “Accounts Receivable” account and crediting the “Sales” account. Purchase of inventory should be recorded by debiting the “Purchases” account and crediting the “Accounts Payable” account.
In the periodic inventory system, the closing entry should be made at the end of the accounting period to update the “Inventory” and “Cost of Goods Sold” accounts.
Beginning inventory = 3,000 × $75 = $225,000
Total units available for sale = 3,000 + 4,500 + 3,500 = 11,000 units
Inventory’s total cost = 3,000 × $75 + 4,500 × $80 + 3,500 × $90 = $900,000
Weighted average unit cost = $900,000 ÷ 11,000 = $81.82
Purchases = 4,500 × $80 + 3,500 × $90 = $675,000
Units sold = 1,600 + 2,300 + 2,800 = 6,700 units
Ending inventory = 11,000 – 6,700 = 4,300 units
Ending inventory cost = 4,300 × $81.82 = $351,818.18
COGS = $225,000 + $675,000 – $351,818.18 = $548,181.82
Thus, the closing entry should look as follows:
In the perpetual inventory system, the update of the “Inventory” account balance and “Cost of Goods Sold” account balance is made each time a purchase or sale is made.
Jun 1
Inventory is represented by 3,000 units at a cost of $75 per unit.
Jun 6
COGS = 1,600 × $75 = $120,000
Inventory Account Balance = (3,000 – 1,600) × $75 = $105,000
Jun 9
Purchase = 4,500 × $80 = $360,000
Inventory Account Balance = $105,000 + $360,000 = $465,000
Weighted average unit cost = $465,000 ÷ (1,400 + 4,500) = $78.81
Jun 14
COGS = 2,300 × $78.81 = $181,271.19
Inventory Account Balance = $465,000 – $181,271.19 = $283,728.81Jun 23
COGS = 2,800 × $78.81 = $220,677.97
Inventory Account Balance = $283,728.81 – $220,677.97 = $63,050.84
Jun 23
Purchase = 3,500 × $90 = $315,000
Inventory Account Balance = $63,050.84 + $315,000 = $378,050.85
If all purchases and sales are made on credit, journal entries should look as follows:
Any sale requires two entries in the journal. The first entry is debiting the “Accounts Receivable” account and crediting the “Sales” account by sale value. The second entry is debiting the “Cost of Goods Sold” account and crediting the “Inventories” account by the cost of goods sold value.
Any purchase of inventory is recorded by debiting the “Inventory” account and crediting the “Accounts Payable” account.