Moving Average Inventory Method
The moving average inventory method is an accounting technique used to calculate the cost of inventory that assumes both the cost of goods sold (COGS) and the ending inventory consist of a mix of all the goods available for sale.
Here’s how it works:
Every time a new inventory purchase is made, a new weighted average cost per unit is calculated. This is done by taking the total cost of items available for sale (both old and new) and dividing it by the total number of units available for sale. This weighted average cost per unit is then used to value the COGS and ending inventory whenever a sale is made.
This method is called “moving average” because the average cost per unit changes, or moves, whenever a purchase is made. The moving average method smooths out price changes and can be more accurate than other methods in certain situations.
Example of the Moving Average Inventory Method
I’ll extend the previous example to show how the moving average cost per unit changes with a new purchase.
Let’s say we’re running a business that sells chairs, and we made the following transactions:
- We started the month by purchasing 10 chairs for $20 each, so our initial inventory cost is $200 (10 chairs * $20).
- A week later, we purchased an additional 10 chairs, but this time for $25 each, which is a total of $250. Now, our total inventory cost is $450 (initial $200 + additional $250), and we have 20 chairs in stock.
- We calculate our moving average cost per unit by dividing the total inventory cost by the total number of units. That’s $450 / 20 chairs = $22.50 per chair.
- Now, let’s say we sell 5 chairs. The cost of goods sold (COGS) would be calculated using our average cost per chair. So, our COGS is 5 chairs * $22.50 = $112.50.
- After this sale, we have 15 chairs left in inventory, and the value of the remaining inventory would also be calculated using our average cost. So, the value of our remaining inventory is 15 chairs * $22.50 = $337.50.
- Later in the month, we purchase another 10 chairs for $30 each (total $300). Now, we have 25 chairs in inventory (15 remaining from before + 10 new ones), and our total inventory cost is $637.50 (previous inventory value $337.50 + cost of new chairs $300).
- We again calculate our moving average cost per unit, which is now $637.50 / 25 chairs = $25.50 per chair. This becomes the new cost per unit for calculating COGS and inventory value for the next transactions.
As you can see, the average cost per unit changes whenever a new purchase is made, hence the name “moving average” inventory method. It ensures that the cost assigned to inventory sold and remaining inventory reflects the most recent cost information.
