FA 34 - Inventory - Weighted Average (Average Cost) Method

Summary

This video script explains the concept of weighted average in inventory accounting through a relatable gas tank analogy. It walks through a step-by-step example of calculating the weighted average cost of inventory, including purchases and sales, and demonstrates how to record journal entries for these transactions. The script clarifies the process of adjusting the average cost after each purchase and sale, emphasizing the importance of this method in determining cost of goods sold and gross profit.

Takeaways

• 📘 The script discusses the weighted average method of inventory valuation, emphasizing its difference from simple average calculations.
• 🚗 It uses the gas tank analogy to explain the concept of weighted average, where the cost of the initial amount of gas in the tank influences the average cost more than the subsequent addition.
• 🔢 The weighted average is calculated by dividing the total cost of all items by the total quantity, not by averaging the individual costs of each batch.
• 🛒 The script provides a step-by-step example of how to apply the weighted average method to inventory transactions, including purchases and sales.
• 📈 The example illustrates the process of recalculating the average cost after each inventory transaction, showing how the new average is determined.
• 💰 The cost of goods sold (COGS) is recalculated using the weighted average method after each sale, affecting the gross profit calculation.
• 📋 The script mentions that the sales revenue remains constant regardless of the inventory valuation method used, but the COGS and thus the gross profit can vary.
• 📝 Journal entries are provided for the purchase and sale transactions, showing how they are recorded under the weighted average method.
• ✍️ The journal entries for purchases are consistent across all inventory valuation methods, but the COGS entries differ based on the method used.
• 🗓️ Specific dates are given for the transactions, such as May 24th for a purchase and May 31st for a sale, to demonstrate the application of the weighted average method in a real-world scenario.
• 👍 The presenter encourages viewers to give the video a thumbs up if it helped them understand the FIFO, LIFO, and weighted average methods better.

Q & A

What is the concept of weighted average in inventory valuation?

The weighted average in inventory valuation is a method where the cost of goods is averaged across all inventory items, taking into account the quantity and cost of each item. It reflects the overall cost of the inventory, rather than the cost of individual items sold.

Can you explain the 'gas tank' example used in the script to illustrate the weighted average concept?

The 'gas tank' example demonstrates how the weighted average is calculated by considering the total quantity and cost of gas in a tank. If you add more expensive gas to a tank already filled with cheaper gas, the average cost of the gas in the tank is not the simple average of the two prices but rather the total cost of gas divided by the total quantity in the tank.

What is the formula for calculating the weighted average cost of inventory?

The formula for calculating the weighted average cost of inventory is: Total Cost of Inventory / Total Quantity of Inventory.

How does the weighted average method differ from FIFO and LIFO in inventory valuation?

The weighted average method differs from FIFO (First In, First Out) and LIFO (Last In, First Out) in that it does not assign costs based on the order of items purchased or sold. Instead, it takes into account all items in inventory and calculates an average cost.

What is the initial average cost of inventory in the script's example on May 1st?

The initial average cost of inventory on May 1st is $3 per unit, with 20 units in the beginning inventory, totaling $60.

What is the total cost of the purchase made on May 5th, and how many units were purchased?

On May 5th, 5 units were purchased at a cost of $3.25 per unit, resulting in a total cost of $16.25.

How is the new average cost of inventory calculated after the purchase on May 5th?

After the purchase on May 5th, the new average cost is calculated by adding the total cost of the new purchase to the previous total cost ($60 + $16.25) and dividing by the new total quantity (20 + 5), resulting in an average cost of $3.05 per unit.

What is the total sales revenue and cost of goods sold (COGS) after the sales on May 31st?

After the sales on May 31st, the total sales revenue is $350, and the cost of goods sold (COGS) is $112.

How does the weighted average method affect the calculation of gross profit?

The gross profit is calculated by subtracting the cost of goods sold (COGS) from the total sales revenue. The weighted average method affects the COGS by averaging the cost of all inventory items, which can result in a different gross profit compared to FIFO or LIFO methods.

What are the journal entries made on May 24th and May 31st according to the weighted average method?

On May 24th, a debit is made to inventory and a credit to accounts payable for the amount of the purchase ($18.50). On May 31st, a debit is made to accounts receivable or cash and a credit to sales revenue for the amount of the sale ($130). Additionally, a debit is made to COGS and a credit to inventory for the cost of the items sold ($45.50).

Outlines

00:00

📈 Weighted Average Inventory Method Explained

This paragraph explains the concept of the weighted average inventory method using a gas tank analogy. The presenter clarifies that weighted average is not a simple mean between two prices but rather a calculation that gives more weight to the larger quantity. The example provided involves adding 99 liters of gas at $1 per liter and then 1 more liter at $2 per liter, resulting in a weighted average cost of $1.01 per liter. The principle is then applied to an inventory problem, starting with 20 units at $3 each, followed by a purchase of 5 units at $3.25 each, and recalculating the average cost to $3.05 after each transaction. Sales are simplified as they are based on the average cost of inventory, regardless of the order of purchases.

05:02

🔍 Journal Entries for Inventory Transactions

The second paragraph delves into the accounting aspect of inventory management, focusing on journal entries for the weighted average method. It starts by calculating the cost of goods sold (COGS) and the remaining inventory value after sales, using the weighted average cost. The presenter then provides a step-by-step guide on how to record journal entries for purchases and sales, emphasizing the consistency of these entries across different inventory valuation methods. The example includes a purchase made on May 24th for $18.50 and a sale on May 31st, with COGS calculated at $45.50. The paragraph concludes with a summary of sales revenue, COGS, and gross profit, highlighting the differences in COGS between the weighted average method and other methods like FIFO and LIFO.

Keywords

💡FIFO

FIFO stands for 'First-In, First-Out,' which is a method of accounting for inventory where the oldest items are sold or used first. In the video, FIFO is one of the inventory valuation methods discussed, and it's compared to LIFO and weighted average methods to illustrate different approaches to calculating cost of goods sold.

💡LIFO

LIFO stands for 'Last-In, First-Out,' another inventory valuation method where the most recently acquired items are sold or used first. The video script mentions LIFO as one of the three methods being compared, and it's used to highlight the differences in inventory cost calculations.

💡Weighted Average

Weighted average is a method of calculating the average cost of goods in inventory by considering the quantity and cost of each item. The video uses the weighted average method to explain how to determine the average cost of gas in a tank, and it is the main focus of the script, providing a step-by-step example of its application in inventory accounting.

💡Inventory Valuation

Inventory valuation is the process of determining the cost of the inventory on hand. The video script discusses different methods of inventory valuation, including FIFO, LIFO, and weighted average, to demonstrate how they affect the calculation of cost of goods sold and gross profit.

💡Cost of Goods Sold (COGS)

Cost of goods sold refers to the direct costs attributable to the production of the goods sold in a company. In the video, the calculation of COGS is central to the discussion, as different inventory valuation methods yield different COGS figures, affecting the company's gross profit.

💡Gross Profit

Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, but before deducting other expenses. The video script explains how gross profit is calculated by subtracting COGS from total sales revenue, and how it varies with different inventory valuation methods.

💡Journal Entries

Journal entries are the financial transactions recorded in the books of accounts. The script mentions journal entries in the context of recording purchases and sales, illustrating the accounting treatment under different inventory valuation methods for May 24th and May 31st.

💡Average Cost

Average cost is the mean value of the total cost of items divided by the quantity of items. The video script uses the concept of average cost to explain the weighted average method, contrasting it with the simple average by using the gas tank example.

💡Beginning Inventory

Beginning inventory refers to the stock of goods on hand at the start of an accounting period. In the script, the beginning inventory is given as 20 units at $3 each, which sets the foundation for subsequent calculations of weighted average cost and COGS.

💡Purchase

A purchase in the context of the video refers to the acquisition of new inventory items. The script details multiple purchases made throughout the month, each affecting the weighted average cost of inventory and the subsequent COGS calculation.

💡Sales

Sales in the video script refer to the act of selling inventory items. The script explains how sales are recorded in the weighted average method, emphasizing that the average cost of inventory is used to calculate the cost of goods sold for each sale.

Highlights

Introduction to the concept of weighted average in inventory valuation.

Explanation of the gas tank analogy to understand weighted average.

Illustration of calculating weighted average with a practical example of gas prices.

Clarification that weighted average is not the simple average of prices.

Description of the beginning inventory and its valuation on May 1st.

Process of updating the weighted average after a purchase on May 5th.

Calculation of the new average cost of inventory after the purchase.

Explanation of how sales affect the weighted average cost of inventory.

Demonstration of calculating the cost of goods sold using the weighted average method.

Update of the weighted average after another purchase on May 20th.

Calculation of the new weighted average cost after the May 20th purchase.

Process of updating the inventory valuation after a purchase on May 24th.

Final calculation of the weighted average cost after the May 24th purchase.

Explanation of the sale process and its impact on the weighted average cost.

Calculation of the cost of goods sold and the remaining inventory value on May 31st.

Completion of the inventory table and calculation of sales, COGS, and gross profit.

Journal entries for the purchase on May 24th under the weighted average method.

Journal entries for the sale on May 31st and the impact on COGS.

Summary of the weighted average method's application and its challenges.

Encouragement for viewers to give a thumbs up for understanding FIFO, LIFO, and weighted average methods.

Transcripts

we've been working their way through

this 72a this FIFO LIFO weighted average

problem and now we're on to weighted

average the third one is the the

trickiest of the three and I always like

to and I will react splain this when I

think of weighted average I always think

of this gas tank example if I put 99

liters in my car and it cost me $1 per

litre means I got 99 dollars worth of

gas in my car and let's say it's a

hundred liter gas tank and I put one

more leader in at two dollars per liter

so that's two dollars worth of gas in

the tank and somebody asks me what's the

average cost of the gas in your gas tank

I wouldn't say oh well it's a buck 50

you know the average between one and two

one plus two divided by two right I

wouldn't say it's a buck fifty because

of course you know I've got some gas

that's a dollar and some guess it's two

dollars so I've got a buck fifty on

average is the cost of gas and my gas

tank that's a simple average a weighted

average would say no no this 99 litre

should take precedence so if the 99

liters takes precedent that means it

should have more weight in our average

and it does if we take a weighted

average here's how you do it

you total the number of units in this

case leaders you total the total cost in

this case 101 dollars 99 plus two and

then rather than taking average between

one and two you just go 101 divided by

100 and you get one point zero one

that's 101 over 100 and that is your

weighted average well that principle is

just all over this problem so let's do

it our beginning inventory twenty at

three dollars on May the 1st so that is

our average 20 at three four sixty bucks

okay so next May the fifth we make a

purchase now whenever we make a purchase

we've got work to do as weighted

averages so we sorry I missed the

purchases column we purchase five at

three twenty five and five times three

twenty five is six

25 we had 20 at $3 for 60 we're adding

to it 5 at 325 for 1625 and now I need

to reassess how do I do that well I add

my total quantity I had my total cost

and then I divide the two so 20 plus 5

is of course 25 60 plus 16 is of course

76 76 point 2 5 divided by 25 gives us

3.05 and you can see it's not rounding

at all 3.0 5 is the number so our

average cost of inventory is 305 now

when I make sales the sales are easy

because I don't have to say what did I

buy first what did I buy last and keep

track I just say oh I sold twenty two

pieces of inventory they all cost 305

right that's the average cost of my

inventory so 22 times 305 is 67 ten if I

had 25 units I sold 22 I'm left with 3

at 3:05 + 3 times 305 is 915 moving on

to May 20th on May 20th I make a

purchase I purchase 7 units at 3:55 7

times 3 55 is 2485 ok so now I had 3 at

3:05 for 9.15 I'm adding to it 7 at 355

for 2485 summing it up here

three plus seven is ten nine plus 24 is

34 34 divided by 10 gives us three

dollars and 40 cents as our weighted

average their May 24th I make another

purchase I purchase five at three

dollars and seventy cents five times

three seventy is eighteen fifty and I

had ten units at three forty four thirty

four thirty four dollars I'm adding five

at 374 eighteen fifty again summing it

up riajuu don't want to shift cells up

control you underlined is what I wanted

to do here 10 plus 5 is 15 34 plus 18 50

is 52 50 52 50 divided by 15 is three

dollars and fifty cents that's my

average cost now on May 31st I make a

sale what do I sell I sell 13 units

what's the average cost of goods sold

350 now again we're keeping in mind I

recognize that the revenue here is $130

but that number doesn't go anywhere on

the chart right the chart is all about

cost 22 times 10 is 220 we're gonna use

those numbers later 13 times 350 though

45 50 leaving me two units at 350 for

$7.00 and that point we have completed

our inventory table here we got a

compute sales cogs and gross profit our

sales Rev 220 plus 130 our total sales

revenue is 350 dollars this did not

change across the methods same every

time our cost of goods sold the sum of

this column 67 plus 45 equals 67 plus 45

112 bucks 350 minus 112 is 237

- cogs is gross profit okay last step

here do a couple of journal entries May

24th we make a purchase well this is

always the same when you make a purchase

debit inventory credit AP by the way I'm

answering Part C here just do journal

entries for May 24th and May 31st under

all methods so that's what we're doing

debit inventory credit AP for the amount

of the purchase on May 24th which was

$18.50 this is not different under any

method on May 31st I make a sale

remember whenever we make a sale there's

always two pieces debit AR or cash so

I'm clear here credit sales sales Rev

that amount hasn't changed it's a

hundred and thirty bucks

the only difference between all of our

methods is this cogs amount cost of

goods sold double cogs credit inventory

for the amount from our table for this

amount 45 dollars and fifty cents in

this case it was different in the other

two methods okay there we have it we

have salt 72 a we've made it to the

bottom and we've done the weighted

average method which i think is a little

more challenging if this has helped you

in better understanding FIFO LIFO

weighted average method I do hope you'll

give this video the thumbs up alright

that's all for this video see you next

time