# The Blueprint Guide to the Weighted Average Cost Method

A guide to how the weighted average cost method works and why it may or may not work for your business.

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The Stormlight Archive and Atlas Shrugged are two of the longest books I’ve read. They come in at more than a thousand pages and over 55 hours listening time if you, like me, choose the audiobook route.

Sometimes it feels like reading about all the ways you can account for inventory would take just as long. Should you use FIFO or LIFO? Should you use periodic or perpetual?

Today we’re looking at another option: the weighted average cost method. Read on to learn how this method differs from the FIFO and LIFO methods as well as the advantages and disadvantages of using it in your business.

## Overview: What is weighted average cost?

Most businesses using a periodic inventory system use the first-in, first-out (FIFO) or last-in, first-out (LIFO) methods to calculate inventory. These methods tie a price to every unit of inventory and then calculate cost of goods sold (COGS) based on which units were sold.

This approach isn’t feasible for everyone. If you sell homogeneous inventory that's constantly restocked, it can be impossible to track what unit was purchased for what price.

Weighted average inventory solves this problem. Instead of attempting to tie a price to each unit, the method uses a weighted cost that averages the price of all inventory that has been purchased. This simplifies things at period end, when inventory numbers are finalized.

### Weighted average vs. FIFO vs. LIFO: What's the difference?

Let’s take a look at how cost of goods sold and ending inventory would be calculated using the three methods.

The resulting COGS from each method are around the same level.

In this example, there's a beginning inventory balance, three purchases of different unit amounts, and then a sale of 250 units. To calculate cost of goods sold, we need to either pick which 250 units were sold, or come up with an average price to apply to the sold units.

Using FIFO, the 120 units in beginning inventory, 80 purchased on June 1, and 50 of the units purchased on June 5 were included in the COGS calculation.

LIFO uses all of the units purchased in June and 30 of the units in beginning inventory.

The weighted average cost takes the average of each purchase, weighted by the number of units purchased, and applies that to the number of units sold. We will go over how to calculate the weighted average for this example in the next section.

There isn’t much difference in COGS between the three methods because of the small numbers used in the example. However, businesses that quickly turn inventory or have bigger price jumps than in this example can see that difference quickly add up to a more impactful change to the income statement.

The difference between LIFO and FIFO is which units are used to calculate cost of goods sold. Weighted average uses an average of all units in inventory.

## How to calculate weighted average cost

Here’s how we calculated the weighted average cost in the example above:

The average cost is calculated by weighting each transaction by the number of units purchased.

When the sale is made on June 10, there are 340 units of inventory. We start by finding what percent of total inventory each transaction accounts for by dividing the number of units in it by the total of 340.

Then, multiply that percentage by the price for each transaction to find the adjusted price. Finally, sum the adjusted prices to get the weighted average cost of \$12.08, and multiply that by the number of units sold to find the cost of goods sold of \$3,019.85.

The new beginning inventory is 90 units (340 total units - 250 units sold) with an average price of \$12.08, totaling \$1,087.15. You can also calculate this by subtracting the cost of goods sold from the total cost of inventory prior to the sale (340 units x \$12.08 average price).

It's a good practice to count inventory at the end of each period and compare it with the calculated ending inventory in order to find any shrinkage. Shrinkage is the loss of inventory due to damage, loss, or theft.

### Advantages of the weighted average cost method

Here are a few advantages to using weighted cost:

• You don’t have to tie prices to units: The most time-consuming part of the LIFO and FIFO methods is tracking every batch that comes in along with its price to ensure items are sold in the correct order. With the weighted average cost method, when inventory comes in, you just record the purchase and update the current weighted average cost.
• You may be able to pay less for accounting software: While we certainly don’t recommend skimping on accounting software, if you’re just starting out and don’t even have a second employee, the weighted average cost method would make it easier to just track inventory on a spreadsheet — or even by hand.
• You have a consistent price: With FIFO and LIFO, profits are based on either the oldest or most recent purchases. If there's been a significant price change, the calculated COGS and gross margin won't be accurate and could lead to bad decisions. If you have a running weighted average cost in mind when setting prices and making purchases, it will lead to better decisions.