Moving Average Formula For Inventory Costs

Post on Tuesday, July 10th, 2018 in Accounting

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Product cost variations affect the value of inventory and complicate the process of calculating costs of goods sold. For SMBs and larger corporations, proper inventory management translates to tracking the costs of goods along the supply chain until when they’re sold. Goods that are marred by price fluctuations present a greater challenge as they make the cost calculation process an arduous task.

The common methods for evaluating the value of goods in the inventory are the FIFO and LIFO techniques. While these techniques are easy and provide an effortless way of calculating the value of your inventory, they don’t always give you the same value.

Knowing the correct cost of your goods after receiving a purchase order is essential as it directly influences the amount you’re going to remit to the tax man.

The average inventory formula is oft-used by corporations that need to maintain an accurate account of the inventory costs. As the name suggests, it allows businesses to calculate the average value of unit costs upon arrival of a purchase order. Therefore, moving average method keeps your balance sheet up-to-date as per the costs of the goods in the inventory.

Moving Average Formula For Calculating Inventory Cost

The value you get after applying moving average formula falls between what LIFO and FIFO would provide. Typically, prices of goods tend to rise over time, an implication that newly acquired goods are costlier than those acquired earlier. That’s the reason why FIFO would always report a value less than what moving average formula would report. On the other hand, LIFO would report a value that’s higher than FIFO.

So, how can you calculate the average inventory cost?

Let’s present this in a way you can quickly understand. Let’s assume the cost and quantity of coffee beans arriving at a Starbucks warehouse every month for four months are as follows:

Date

Quantity

Purchase Unit Price ($)

Value

Moving Average Unit Cost

01/01/2018

15

5

75

5.0

02/01/2018

10

6

60

5.4

03/01/2018

20

6

120

5.7

04/01/2018

15

7

105

6.0

Calculating Cost through Moving Average Formula

With this method, the cost of goods is updated when the goods are received in the warehouse. So, let’s see how you arrive at the average cost. 

January

Unit Cost = $5.00

February

Unit Cost = $5.40

March

Unit Cost = $5.70

April

Unit Cost = $6.00

With this technique, you eliminate multiple unit prices that doesn’t give you the true picture of the average costs of your inventory over a particular period. For the case above, the unit cost as of April was $6. If you’re dealing with goods whose prices fluctuates often, then the average cost calculator can help you get the correct inventory value.

Let’s compare the values of the inventory as of April when calculated using FIFO and LIFO. Note that when calculating using FIFO, you start from the oldest to the most recent.  Conversely, LIFO involves calculating inventory costs from the most recent to the oldest value.   

Comparing LIFO, FIFO & Moving Inventory Formula

Assuming that on April 3 and 4, 15 units and 30 units were sold respectively. So the total units sold are 45. The costs of the sold stock using the three methods produces different results as illustrated below: 

  • Using FIFO, Jan-Mar orders are considered. That translates to $255 (75+60+120).
  • For the case of LIFO, Apr-Feb orders are considered. The costs translates to $285 (105+120+60)
  • By using the average formula, the cost of the 45 units is $270 (45 * 6).

By using this formula, you’ll arrive at a value that lies between what’s indicated by FIFO and LIFO. Therefore, the average cost formula is suitable for computing costs of the goods in the inventory every fiscal year.

It is not only accurate, but also provides inventory managers with a single value that can be used to calculate costs of goods sold anytime. The value is recalculated every time a new purchase order is received.

Can Average Unit Cost Formula Apply If There Are Backdated Entries?

The unit costs must be recalculated starting from the effective date of those backdated entries. Time and quantity of stock is vital in evaluating the costs of goods sold using the moving average inventory calculator. Ensuring that you enter all orders as they arrive will help in alleviating problems that may prompt backdating of entries.

What Happens When The Purchase Order Doesn’t Include Other Charges?

Sometimes, you may receive goods but you still have to wait for other invoices to make the purchase order complete. We recommend that you record the value of the purchase order as it arrives and update it every time an invoice related to the order arrives.

Advantages of the Moving Unit Cost Calculation Method

Because you’re updating the costs as soon as new goods are accepted, you’ll have the most recent value of goods sold. This is ideal for forecasting purposes. You can generate a graph to see how the moving average value has been changing throughout the year and extrapolate it to see how the costs would look in future.

With this method, you can sell goods in stock without paying attention to their purchase order tags. Costs are evaluated based on the current moving average, which is updated every time incoming stock is recorded.

It’s more accurate than other methods used to determine the value of the inventory. By using this technique you won’t be vindicated for undervaluing your goods to evade tax. Moreover, chances of overvaluing your stock are small because you’re slicing a significant amount of tax you’d pay by using the LIFO method.

For companies using perpetual inventory systems, the moving average method offers a reliable solution for computing the costs of goods sold. With this system where automatic entries are made whenever an item is received or released from the inventory, the use of this average inventory calculation technique is crucial for keeping the inventory system up-to-date.

It’s important to note that companies running franchises in various regions may have to calculate average stock costs at the warehouse level rather than on the company level. This is because similar items in different regions usually have different price tags. Once, these prices have been calculated, they can be harmonized using other accounting methods at the company level.

Dynamic Inventory Moving Average Cost Calculator 

Dynamic Inventory allows you concentrate on the most important administrative aspects of your business by overseeing your inventory using our inventory management system. We help eliminate tedious excel worksheets for inventory management and irksome continuous FIFOs and LIFOs calculations.

The average cost method works for most businesses, but our software can accommodate all other methods of evaluating the value of your inventory. Always remember to choose the right cost calculation method for your business. 

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Adam is the Assistant Director of Operations at Dynamic Inventory. He has experience working with retailers in various industries including sporting goods, automotive parts, outdoor equipment, and more. His background is in e-commerce internet marketing and he has helped design the requirements for many features in Dynamic Inventory based on his expertise managing and marketing products online.

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