Inventory valuation is important for businesses and can be done through methods such as FIFO, LIFO, and weighted average inventory. The latter creates an average cost for all goods ready to sell. Failure to properly value inventory can distort a company’s balance sheet and income statement. Weighted average inventory can smooth out the cost of goods sold over time but can be affected by significant cost increases.
Inventory is an important accounting concept for retail, manufacturing, and similar businesses. There are many different methods for this purpose, such as first in, first out (FIFO); last in first out; and weighted average inventory. The last option is quite common in business, although FIFO is perhaps the most popular option among the three. Weighted average inventory creates an average cost for all the goods a company has ready to sell in its finished goods account. The most basic formula for this inventory valuation method is to add up all inventory items produced or purchased and divide the number by the associated total 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 in the company’s balance sheet. The cost of goods sold resides in the income statement; Incorrect inventory valuation here distorts a company’s gross and net profits for a given period. Companies are free to select one of the three inventory valuation methods mentioned above. In most cases, the company must disclose any methods it uses to interested parties through a financial statement.
The valuation of the weighted average inventory is completed with an automated computerized management system. For example, each time a company completes or purchases new products, a cost report or invoice is sent to the company’s accounting department. An accountant reviews the document for accuracy and validity and 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 places this cost per unit for each item of this category of goods sold.
One of the biggest benefits to weighted average inventory is the ability of this valuation method to smooth out the cost of goods sold over a long period of time. The inventory account also has a less volatile account balance since the average cost of inventory is around the same amount for a specified number of goods. This is beneficial, as the company can be presented as a model of consistency to external stakeholders, who are likely to assume that a company is not misrepresenting inventory. Problems can arise, however, as significant cost increases for subsequent inventory purchases will push cheaper inventory costs to a new, higher average cost of items available for sale.
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