Weighted Average Cost Flow Assumption

6.2: Inventory Cost Flow Assumptions

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learning objective

LO1 – Summate cost of appurtenances sold and trade inventory using specific identification, first in commencement-out (FIFO), and weighted average cost menstruum assumptions — perpetual.

Determining the cost of each unit of inventory, and thus the full cost of ending inventory on the residuum canvass, can be challenging. Why? We know from Affiliate five that the toll of inventory can be affected past discounts, returns, transportation costs, and shrinkage. Additionally, the purchase cost of an inventory item tin can be different from one buy to the next. For example, the cost of coffee beans could be $five.00 a kilo in October and $7.00 a kilo in November. Finally, some types of inventory flow into and out of the warehouse in a specific sequence, while others do not. For example, milk would need to be managed and so that the oldest milk is sold offset. In dissimilarity, a automobile dealership has no control over which vehicles are sold because customers brand specific choices based on what is available. Then how is the toll of a unit in merchandise inventory determined? There are several methods that tin can be used. Each method may consequence in a different toll, as described in the following sections.

Assume a company sells but ane product and uses the perpetual inventory arrangement. It has no beginning inventory at June 1, 2015. The visitor purchased 5 units during June as shown in Effigy vi.two.i.

	Buy Transaction
Date	Number of units	Cost per unit of measurement
June 1	1	$1
5	ane	2
7	i	3
21	1	4
28	ane	5
	five	$15

Figure $\PageIndex{1}$: June Purchases and Purchase Price per Unit of measurement

The entry to record the June 30 sale on account would exist:

Full general Journal
Date	Business relationship/Explanation	F	Debit	Credit
	Accounts Receivable		40
	Sales			40
	To record the sale of merchandise on account.
	Price of Goods Sold		11
	Merchandise Inventory			11
	To record the cost of the sale.

It is not possible to utilize specific identification when inventory consists of a large number of like, inexpensive items that cannot be hands differentiated. Consequently, a method of assigning costs to inventory items based on an causeless flow of goods tin can be adopted. 2 such generally accepted methods, known as cost menses assumptions, are discussed next.

The Starting time-in, First-out (FIFO) Cost Period Assumption

First-in, kickoff-out (FIFO) assumes that the showtime goods purchased are the start ones sold. A FIFO cost flow assumption makes sense when inventory consists of perishable items such as groceries and other time-sensitive goods.

Using the data from the previous example, the kickoff four units purchased are assumed to exist the first four units sold under FIFO. The cost of the 4 units sold is $10 ($1 + $two + $3 + $4). Sales still equal $40, then gross profit nether FIFO is $xxx ($40 – $ten). The toll of the one remaining unit in ending inventory would be the cost of the fifth unit purchased ($v).

The general ledger T-accounts for Merchandise Inventory and Toll of Goods Sold as illustrated in Figure 6.2.2 would show:

Figure $\PageIndex{2}$: Cost of Goods Sold using FIFO

The entry to tape the sale would exist:

Full general Journal
Date	Account/Explanation	F	Debit	Credit
	Accounts Receivable		40
	Sales			twoscore
	To record the auction of merchandise on account.
	Price of Goods Sold		x
	Trade Inventory			10
	To record the toll of the sale.

The Weighted Average Cost Flow Assumption

A weighted average cost menses is assumed when appurtenances purchased on different dates are mixed with each other. The weighted average cost assumption is popular in practice considering information technology is piece of cake to summate. It is also suitable when inventory is held in common storage facilities — for case, when several rough oil shipments are stored in one large property tank. To calculate a weighted boilerplate, the total cost of all purchases of a particular inventory type is divided by the number of units purchased.

To calculate the weighted average cost in our example, the purchase prices for all five units are totaled ($ane + $2 + $3 + $4 + $5 = $15) and divided past the total number of units purchased (v). The weighted average cost for each unit is $3 ($15/5). The weighted average cost of appurtenances sold would exist $12 (4 units @ $three). Sales nevertheless equal $40 resulting in a gross turn a profit under weighted average of $28 ($40 – $12). The cost of the one remaining unit of measurement in ending inventory is $3.

The full general ledger T-accounts for Trade Inventory and Cost of Goods Sold are:

Figure $\PageIndex{three}$: Cost of Goods Sold using Weighted Boilerplate

The entry to record the sale would be:

General Periodical
Appointment	Account/Explanation	F	Debit	Credit
	Accounts Receivable		twoscore
	Sales			twoscore
	To record the sale of trade on account.
	Cost of Goods Sold		12
	Merchandise Inventory			12
	To record the cost of the sale.

Cost Catamenia Assumptions: A Comprehensive Example

Call up that under the perpetual inventory system, cost of goods sold is calculated and recorded in the accounting organisation at the time when sales are recorded. In our simplified example, all sales occurred on June thirty afterwards all inventory had been purchased. In reality, the purchase and sale of trade is continuous. To demonstrate the calculations when purchases and sales occur continuously throughout the accounting period, permit's review a more than comprehensive example.

Assume the same example every bit above, except that sales of units occur as follows during June:

Appointment	Number of Units Sold
June 3	1
eight	one
23	1
29	1

To assistance with the calculation of cost of goods sold, an inventory record menu will be used to track the private transactions. This card records information near purchases such as the appointment, number of units purchased, and purchase cost per unit. It also records cost of goods sold information: the engagement of sale, number of units sold, and the cost of each unit sold. Finally, the menu records the balance of units on mitt, the cost of each unit held, and the full toll of the units on paw. A partially-completed inventory record card is shown in Figure 6.2.4 below:

Figure $\PageIndex{4}$: Inventory Record Card

In Figure half dozen.ii.4, the inventory at the cease of the accounting period is one unit. This is the number of units on hand according to the accounting records. A concrete inventory count must nevertheless exist done, by and large at the cease of the fiscal year, to verify the quantities really on paw. As discussed in Chapter 5, any discrepancies identified by the physical inventory count are adapted for as shrinkage.

As purchases and sales are made, costs are assigned to the goods using the called cost flow supposition. This information is used to calculate the price of appurtenances sold corporeality for each sales transaction at the time of auction. These costs will vary depending on the inventory price flow assumption used. Every bit nosotros will see in the next sections, the cost of sales may likewise vary depending on when sales occur.

Comprehensive Example—Specific Identification

To use specific identification, we demand data about which units were sold on each date. Assume that specific units were sold as detailed below.

Appointment of Sale	Specific Units Sold
June 3	The unit of measurement sold on June iii was purchased on June 1
8	The unit sold on June viii was purchased on June 7
23	The unit sold on June 23 was purchased on June 5
29	The unit sold on June 29 was purchased on June 28

Using the data higher up to apply specific identification, the resulting inventory record menu appears in Effigy 6.2.5.

Effigy $\PageIndex{5}$: Inventory Record Card using Specific Identification

Discover in Effigy 6.2.vi that the number of units sold plus the units in catastrophe inventory equals the total units that were bachelor for sale. This will always exist true regardless of which inventory cost flow method is used.

Figure $\PageIndex{6}$: Total Units Sold plus Full Units in Catastrophe Inventory equals Total Units Available for Sale

Figure $\PageIndex{7}$: Total Cost of Goods Sold plus Total Cost of Units in Catastrophe Inventory equals Total Cost of Goods Available for Sale (Specific Identification)

Figure vi.2.7 highlights the human relationship in which total cost of goods sold plus total cost of ending inventory equals total cost of goods available for sale. This relationship will e'er exist true for each of specific identification, FIFO, and weighted boilerplate.

Comprehensive Instance—FIFO (Perpetual)

Using the same information, we now utilise the FIFO cost flow supposition equally shown in Figure half-dozen.2.eight.

Figure $\PageIndex{8}$: Inventory Record Bill of fare using FIFO (Perpetual)

When computing the cost of the units sold in FIFO, the oldest unit of measurement in inventory will always be the get-go unit removed. For example, in Effigy half-dozen.ii.eight, on June 8, one unit is sold when the previous balance in inventory consisted of 2 units: 1 unit of measurement purchased on June five that cost $2 and 1 unit purchased on June 7 that cost $3. Because the unit of measurement costing $2 was in inventory starting time (earlier the June 7 unit costing $three), the cost assigned to the unit of measurement sold on June 8 is $2. Under FIFO, the get-go units into inventory are assumed to be the first units removed from inventory when calculating toll of goods sold. Therefore, under FIFO, ending inventory will always be the about recent units purchased. In Effigy 6.ii.8, at that place is i unit in catastrophe inventory and it is assigned the $5 cost of the most recent purchase which was fabricated on June 28.

The information in Figure 6.2.8 is repeated in Effigy 6.two.9 to reinforce that goods bachelor for sale equals the sum of goods sold and ending inventory.

Effigy $\PageIndex{9}$: Total Goods Sold plus Ending Inventory equals Total Goods Available for Auction (FIFO Perpetual)

Comprehensive Instance—Weighted Average (Perpetual)

The inventory record card transactions using weighted average costing are detailed in Effigy half dozen.2.10. For consistency, all weighted average calculations will be rounded to two decimal places. When a perpetual inventory system is used, the weighted average is calculated each time a purchase is fabricated. For example, after the June 7 purchase, the balance in inventory is 2 units with a full cost of $5.00 (ane unit at $2.00 + 1 unit of measurement at $3.00) resulting in an boilerplate cost per unit of $2.fifty ($5.00 ÷ ii units = $2.50). When a sale occurs, the cost of the auction is based on the well-nigh recent average toll per unit. For example, the price of the sale on June three uses the $one.00 average cost per unit of measurement from June 1 while the toll of the sale on June eight uses the $ii.50 average cost per unit from June vii.

Figure $\PageIndex{10}$: Inventory Record Bill of fare using Weighted Average Costing (Perpetual)

A common error fabricated past students when applying weighted boilerplate occurs when the unit of measurement costs are rounded. For example, on June 28, the average cost per unit is rounded to $iv.13 ($eight.25 ÷ 2 units = $4.125/unit rounded to $four.thirteen). On June 29, the cost of the unit of measurement sold is $iv.xiii, the June 28 average cost per unit. Care must be taken to recognize that the total remaining residual in inventory subsequently the June 29 sale is $four.12, calculated as the June 28 ending inventory total dollar corporeality of $8.25 less the June 29 total toll of goods sold of $4.13. Students will oft incorrectly apply the average cost per unit, in this case $4.13, to summate the catastrophe inventory balance. Remember that the cost of appurtenances sold plus the balance in inventory must equal the goods available for sale as highlighted in Figure 6.2.eleven.

Effigy $\PageIndex{eleven}$: Total Goods Sold plus Ending Inventory equals Total Goods Available for Sale (Weighted Average Perpetual)

Figure vi.two.12 compares the results of the three cost flow methods. Goods bachelor for auction, units sold, and units in ending inventory are the same regardless of which method is used. Because each cost menses method allocates the cost of goods bachelor for sale in a particular way, the price of goods sold and ending inventory values are unlike for each method.

Cost Flow Assumption	Total Price of Goods Available for Sale	Total Units Available for Auction	Total Cost of Goods Sold	Full Units Sold	Total Price of Ending Inventory	Full Units in Ending Inventory
Specific Identification	$15.00	v	11.00	four	4.00	1
FIFO	xv.00	5	10.00	4	5.00	1
Weighted Average	15.00	five	10.88	four	four.12	1

Figure $\PageIndex{12}$: Comparing Specific Identification, FIFO, and Weighted Boilerplate

Journal Entries

In Chapter five the journal entries to record the sale of merchandise were introduced. Affiliate 5 showed how the dollar value included in these journal entries is determined. We now know that the information in the inventory record is used to prepare the journal entries in the general periodical. For example, the credit auction on June 23 using weighted average costing would be recorded as follows (refer to Effigy 6.2.12).

General Journal
Date	Business relationship/Caption	F	Debit	Credit
	Accounts Receivable		10.00
	Sales			x.00
	To record credit sale at a selling toll of $x per unit of measurement.
	Cost of Goods Sold		three.25
	Merchandise Inventory			iii.25
	To record the cost of the sale.

Perpetual inventory incorporates an internal control feature that is lost under the periodic inventory method. Losses resulting from theft and error tin can hands be adamant when the actual quantity of goods on paw is counted and compared with the quantities shown in the inventory records equally being on mitt. Information technology may seem that this advantage is offset past the time and expense required to continuously update inventory records, specially where there are thousands of different items of various sizes on mitt. Yet, computerization makes this record keeping easier and less expensive because the inventory accounting organization can be tied in to the sales system so that inventory is updated whenever a sale is recorded.

Inventory Tape Card

In a company such equally a large drugstore or hardware chain, inventory consists of thousands of dissimilar products. For businesses that bear large volumes of many inventory types, the full general ledger merchandise inventory account contains only summarized transactions of the purchases and sales. The detailed transactions for each type of inventory would be recorded in the underlying inventory record cards. The inventory tape bill of fare is an example of a subsidiary ledger, more commonly called a subledger. The merchandise inventory subledger provides a detailed listing of type, amount, and full toll of all types of inventory held at a item point in time. The sum of the balances on each inventory tape card in the subledger would always equal the ending amount recorded in the Merchandise Inventory general ledger account. So a subledger contains the particular for each production in inventory while the full general ledger business relationship shows just a summary. In this manner, the general ledger data is streamlined while allowing for particular to be available through the subledger. There are other types of subledgers: the accounts receivable subledger and the accounts payable subledger. These will be introduced in a subsequent chapter.

Weighted Average Cost Flow Assumption,

Source: https://biz.libretexts.org/Under_Construction/Book%3A_Introduction_to_Financial_Accounting_(Dauderis_and_Annand)/06%3A_Assigning_Costs_to_Merchandise/6.02%3A_Section_2-

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