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Inventory is an important accounting concept for retail, manufacturing, and similar businesses. Many different methods exist for this purpose, such as first in, first out (FIFO); last in, first out; and weighted average inventory. The latter option is quite common in business, though FIFO is perhaps the most popular option among the three. Weighted average inventory creates an average cost for all goods a company has ready to sell in its finished goods account. The most basic formula for this inventory valuation method is to add together all inventory items produced or purchased and divide the number into the total associated cost.
The purpose of inventory valuation is to have the most accurate dollar amounts in two accounts: finished goods inventory and cost of goods sold. Failure to properly value inventory can overstate or understate the company’s finished goods inventory account, creating distortions on the company’s balance sheet. Cost of goods sold resides on the income statement; improper inventory valuation here distorts a company’s gross and net profit for a given period. Companies are free to select one of the three given inventory valuation methods listed above. In most cases, the company must disclose whichever method it uses to stakeholders via a financial statement.
Weighted average inventory valuation is most likely completed using an automated computer management system. For example, every time a company completes or purchases new goods, a cost report or invoice goes to the company’s accounting department. An accountant reviews the document for accuracy and validity then enters it into the company’s software system. Adding more quantity of goods and the associated cost adjusts the total quantity available for sale and the average price per unit. The weighted average inventory valuation process then places this per-unit cost to each item sold from this category of goods.
One of the biggest benefits to weighted average inventory is the ability for this valuation method to smooth the cost of goods sold over a long period of time. The inventory account also has a less volatile account balance as the average cost for inventory hovers around the same amount for a specific number of goods. This is beneficial as the company can present itself as a model of consistency to outside stakeholders, who will most likely assume that a company is not distorting inventory. Problems can arise however, as significant cost increases for later inventory purchases will increase cheaper inventory costs to a new, higher average cost of items available for sale.