Weighted Avg. , Moving Avg. and FIFO,LIFO concept

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After long time, again I am posting some concept of inventory calculation methods, this concepts are very useful and very common.

1.     The Weighted Average Method | Weighted Average Costing

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Weighted Average Method Overview

The weighted average method is used to assign the average cost of production to a product. Weighted average costing is commonly used in situations where:

• Inventory items are so intermingled that it is impossible to assign a specific cost to an individual unit.
• The accounting system is not sufficiently sophisticated to track FIFO or LIFO inventory layers.
• Inventory items are so commoditized (i.e., identical to each other) that there is no way to assign a cost to an individual unit.

When using the weighted average method, divide the cost of goods available for sale by the number of units available for sale, which yields the weighted-average cost per unit. In this calculation, the cost of goods available for sale is the sum of beginning inventory and net purchases. You then use this weighted-average figure to assign a cost to both ending inventory and the cost of goods sold.

The net result of using weighted average costing is that the recorded amount of inventory on hand represents a value somewhere between the oldest and newest units purchased into stock. Similarly, the cost of goods sold will reflect a cost somewhere between that of the oldest and newest units that were sold during the period.

The weighted average method is allowed under both generally accepted accounting principles and international financial reporting standards.

Weighted Average Costing Example

Milagro Corporation elects to use the weighted-average method for the month of May. During that month, it records the following transactions:

	Quantity Change	Actual Unit Cost	Actual Total Cost
Beginning inventory	+150	$220	$33,000
Sale	-125	--	--
Purchase	+200	270	54,000
Sale	-150	--	--
Purchase	+100	290	29,000
Ending inventory	= 175

The actual total cost of all purchased or beginning inventory units in the preceding table is $116,000 ($33,000 + $54,000 + $29,000). The total of all purchased or beginning inventory units is 450 (150 beginning inventory + 300 purchased). The weighted average cost per unit is therefore $257.78 ($116,000 ÷ 450 units.)

The ending inventory valuation is $45,112 (175 units × $257.78 weighted average cost), while the cost of goods sold valuation is $70,890 (275 units × $257.78 weighted average cost). The sum of these two amounts (less a rounding error) equals the $116,000 total actual cost of all purchases and beginning inventory.

In the preceding example, if Milagro used a perpetual inventory system to record its inventory transactions, it would have to recompute the weighted average after every purchase. The following table uses the same information in the preceding example to show the recomputations:

	Units on Hand	Purchases	Cost of Sales	Inventory Total Cost	Inventory Moving- Average Unit Cost
Beginning inventory	150	$         --	$        --	$33,000	$220.00
Sale (125 units @ $220)	25	--	27,500	5,500	220.00
Purchase (200 units @ $270)	225	54,000	--	59,500	264.44
Sale (150 units @ $264.44)	75	--	39,666	19,834	264.44
Purchase (100 units @ $290)	175	29,000	--	48,834	279.05

Note that the cost of goods sold of $67,166 and the ending inventory balance of $48,834 equal $116,000, which matches the total of the costs in the original example. Thus, the totals are the same, but the moving weighted average calculation results in slight differences in the apportionment of costs between the cost of goods sold and ending inventory.

2.    Moving Average Inventory Method

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Moving Average Inventory Method Overview
Under the moving average inventory method, the average cost of each inventory item in stock is re-calculated after every inventory purchase. This method tends to yield inventory valuations and cost of goods sold results that are in-between those derived under the first in, first out (FIFO) method and the last in, first out (LIFO) method. This averaging approach is considered to yield a safe and conservative approach to reporting financial results.

The calculation is the total cost of the items purchased divided by the number of items in stock. The cost of ending inventory and the cost of goods sold are then set at this average cost. No cost layering is needed, as is required for the FIFO and LIFO methods.

Since the moving average cost changes whenever there is a new purchase, the method can only be used with a perpetual inventory tracking system; such a system keeps up-to-date records of inventory balances. You cannot use the moving average inventory method if you are only using a periodic inventory system, since such a system only accumulates information at the end of each accounting period, and does not maintain records at the individual unit level.

Also, when inventory valuations are derived using a computer system, the computer makes it relatively easy to continually adjust inventory valuations with this method. Conversely, it can be quite difficult to use the moving average method when inventory records are being maintained manually, since the clerical staff would be overwhelmed by the volume of required calculations.

Moving Average Inventory Method Example

Example #1: 

ABC International has 1,000 green widgets in stock as of the beginning of April, at a cost per unit of $5. Thus, the beginning inventory balance of green widgets in April is $5,000. ABC then purchases 250 additional greeen widgets on April 10 for $6 each (total purchase of $1,500), and another 750 green widgets on April 20 for $7 each (total purchase of $5,250). In the absence of any sales, this means that the moving average cost per unit at the end of April would be $5.88, which is calculated as a total cost of $11,750 ($5,000 beginning balance + $1,500 purchase + $5,250 purchase), divided by the total on-hand unit count of 2,000 green widgets (1,000 beginning balance + 250 units purchased + 750 units purchased). Thus, the moving average cost of the green widgets was $5 per unit at the beginning of the month, and $5.88 at the end of the month.
We will repeat the example, but now include several sales. Remember that we recalculate the moving average after every transaction.

Example #2: 

ABC International has 1,000 green widgets in stock as of the beginning of April, at a cost per unit of $5. It sells 250 of these units on April 5, and records a charge to the cost of goods sold of $1,250, which is calculated as 250 units x $5 per unit. This means there are now 750 units remaining in stock, at a cost per unit of $5 and a total cost of $3,750.
ABC then purchases 250 additional green widgets on April 10 for $6 each (total purchase of $1,500). The moving average cost is now $5.25, which is calculated as a total cost of $5,250 divided by the 1,000 units still on hand.

ABC then sells 200 units on April 12, and records a charge to the cost of goods sold of $1,050, which is calculated as 200 units x $5.25 per unit. This means there are now 800 units remaining in stock, at a cost per unit of $5.25 and a total cost of $4,200.
Finally, ABC buys an additional 750 green widgets on April 20 for $7 each (total purchase of $5,250). At the end of the month, the moving average cost per unit is $6.10, which is calculated as total costs of $4,200 + $5,250, divided by total remaining units of 800 + 750.
Thus, in the second example, ABC International begins the month with a $5,000 beginning balance of green widgets at a cost of $5 each, sells 250 units at a cost of $5 on April 5, revises its unit cost to $5.25 after a purchase on April 10, sells 200 units at a cost of $5.25 on April 12, and finally revises its unit cost to $6.10 after a purchase on April 20. You can see that the cost per unit changes following an inventory purchase, but not after an inventory sale

3.     Accounting Inventory Methods

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Inventory includes the raw materials, work-in-process, and finished goods that  a company has on hand for its own production processes or for sale to customers. Inventory is considered an asset, so the accountant must consistently use a valid method for assigning costs to inventory in order to record it as an asset.

The valuation of inventory is not a minor issue, because the accounting method used to create a valuation has a direct bearing on the amount of expense charged to the cost of goods sold in an accounting period, and therefore on the amount of income earned. The basic formula for determining the cost of goods sold in an accounting period is:

Beginning inventory + Purchases - Ending inventory = Cost of goods sold

Thus, the cost of goods sold is largely based on the cost assigned to ending inventory, which brings us back to the accounting method used to do so. There are several possible inventory costing methods, which are:

• Specific identification method. Under this approach, you separately track the cost of each item in inventory, and charge the specific cost of an item to the cost of goods sold when you sell the specific item to which that cost has been assigned. This approach requires a massive amount of data tracking, so it is only usable for very high-cost, unique items, such as automobiles or works of art. It is not a viable method in most other situations.

When you buy inventory from suppliers, the price tends to change over time, so you end up with a group of the same item in stock, but with some units costing more than others. As you sell items from stock, you have to decide on a policy of whether to charge items to the cost of goods sold that were presumably bought first, or bought last, or based on an average of the costs of all items in stock. Your choice of a policy will result in using either the first in first out method (FIFO), the last in first out method (LIFO), or the weighted average method. The following bullet points explain each concept:

• First in, first out method. Under the FIFO method, you are assuming that items bought first are also used or sold first, which also means that the items still in stock are the newest ones. This policy closely matches the actual movement of inventory in most companies, and so is preferable simply from a theoretical perspective. In periods of rising prices (which is most of the time in most economies), assuming that the earliest units bought are the first ones used also means that the least expensive units are charged to the cost of goods sold first. This means that the cost of goods sold tends to be lower, which therefore leads to a higher amount of operating earnings, and more income taxes paid. Also, it means that there tend to be fewer inventory layers than under the LIFO method (see next), since you will continually use up the oldest layers.
• Last in, first out method. Under the LIFO method, you are assuming that items bought last are sold first, which also means that the items still in stock are the oldest ones. This policy does not follow the natural flow of inventory in most companies; in fact, the method is banned under International Financial Reporting Standards. In periods of rising prices, assuming that the last units bought are the first ones used also means that the cost of goods sold tends to be higher, which therefore leads to a lower amount of operating earnings, and fewer income taxes paid. There tend to be more inventory layers than under the FIFO method, since the oldest layers may not be flushed out for years.
• Weighted average method. Under the weighted average method, there is only one inventory layer, since the cost of any new inventory purchases are rolled into the cost of any existing inventory to derive a new weighted average cost, which in turn is adjusted again as more inventory is purchased.

Both the FIFO and LIFO methods require the use of inventory layers, under which you have a separate cost for each cluster of inventory items that were purchased at a specific price. This requires a considerable amount of tracking in a database, so both methods work best if inventory is tracked in a computer system.

4.    FIFO vs. LIFO Accounting

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FIFO and LIFO are cost layering methods used to value the cost of goods sold and ending inventory. FIFO is a contraction of the term "first in, first out," and means that the goods first added to inventory are assumed to be the first goods removed from inventory for sale. LIFO is a contraction of the term "last in, first out," and means that the goods last added to inventory are assumed to be the first goods removed from inventory for sale.

Why use one method over the other? Here are some considerations that take into account the fields of accounting, materials flow, and financial analysis:

Issue	FIFO Method	LIFO Method
Materials flow	In most businesses, the actual flow of materials follows FIFO, which makes this a logical choice.	There are few businesses where the oldest items are kept in stock whiler newer items are sold first.
Inflation	If costs are increasing, the first items sold are the least expensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income taxes in the near term.	If costs are increasing, the last items sold are the most expensive, so your cost of goods sold increases, you report fewer profits, and therefore pay a smaller amount of income taxes in the near term.
Deflation	If costs are decreasing, the first items sold are the most expensive, so your cost of goods sold increases, you report fewer profits, and therefore pay a smaller amount of income taxes in the near term.	If costs are decreasing, the last items sold are the least expensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income taxes in the near term.
Financial reporting	There are no GAAP or IFRS restrictions on the use of FIFO in reporting financial results.	IFRS does not all the use of the LIFO method at all. The IRS allows the use of LIFO, but if you use it for any subsidiary, you must also use it for all parts of the reporting entity.
Record keeping	There are usually fewer inventory layers to track in a FIFO system, since the oldest layers are continually used up. This reduces record keeping.	There are usually more inventory layers to track in a LIFO system, since the oldest layers can potentially remain in the system for years. This increases record keeping.
Reporting fluctuations	Since there are few inventory layers, and those layers reflect recent pricing, there are rarely any unusual spikes or drops in the cost of goods sold that are caused by accessing old inventory layers.	There may be many inventory layers, some with costs from a number of years ago. If one of these layers is accessed, it can result in a dramatic increase or decrease in the reported amount of cost of goods sold.

In general, LIFO accounting is not recommended, for the following reasons:

• It is not allowed under IFRS, and a large part of the world uses the IFRS framework.
• The number of layers to track can be substantially larger than would be the case under FIFO.
• If old layers are accessed, costs may be charged to expense that vary substantially from current costs. 

5.     What are perpetual LIFO and periodic LIFO?

The basic concept underlying perpetual LIFO is the last in, first out (LIFO) cost layering system. Under LIFO, you assume that the last item entering inventory is the first one to be used. For example, consider stocking the shelves in a food store, where a customer purchases the item in front, which was likely to be the last item added to the shelf by a clerk. These LIFO transactions are recorded under the perpetual inventory system, where inventory records are constantly updated as inventory-related transactions occur.

The results of a perpetual LIFO system may vary from those generated by a periodic LIFO system, because inventory records in a periodic system are only updated at the end of a reporting period.
The only difference between the two cost flow concepts is how rapidly a costing layer is stripped away or replenished in the costing database. Under perpetual LIFO, there can be a great deal of this activity throughout a reporting period, with inventory layers being added and eliminated potentially as frequently as every day. This means that the costs at which items are sold could vary throughout the period, since costs are being drawn from the most recent of a constantly varying set of cost layers.

Under a periodic LIFO system, however, layers are only stripped away at the end of the period, so that only the very last layers are depleted.

For example, ABC International acquires 10 green widgets on January 15 for $5, and acquires another 10 green widgets at the end of the month for $7. ABC sells five green widgets on January 16. Under a perpetual LIFO system, you would charge the cost of the five widgets sold on January 16 to the cost of goods sold as soon as the sale occurs, which means that the cost of goods sold is $25 (5 units x $5 each). Under a periodic LIFO system, you would wait until the end of the month and then record the sale, which means that you remove five units from the last layer recorded at the end of the month, which results in a charge to the cost of goods sold of $35 (5 units x $7 each).
In a period of continually increasing prices, a periodic LIFO system will result in the highest cost of goods sold and therefore the lowest net income, since it will always use up the most recently purchased inventory first. Conversely, in a period of decreasing prices, the reverse would be true.
The costing results of a perpetual LIFO system are more common than a periodic LIFO system, since most inventory is now tracked using computerized systems that maintain inventory records on a real-time basis.

                          Thank Y0u - Subrat Kumar