Cambrige AS and A Level Accounting Notes (9706)/ ZIMSEC  Advanced Accounting Level Notes: Inventory valuation: Inventory valuation methods: Weighted Average Cost(AVCO)

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  • As already pointed out in the introduction to inventory valuation methods
  • There are several valuation methods that can be used to determine the cost value of inventory
  • AVCO- Average Cost/Weighted Average Cost is one of these methods
  • The assumption here is that all inventory items have a chance to be selected that for issue/sales that is equal to their relative amounts
  • This does indeed make sense were items are just mixed up
  • For example a seller of cheap earrings/shoes can place of the items in a large container near the point of sale
  • Whenever the earrings inventory is low the owner replenishes them by adding more earrings/shoes into the container
  • As people search for pairs there continually mix up the items the result is that it is hard to know which inventory item is sold when
Cost of Sales/Used InventoryCost of closing inventory
For costing purposes, the average cost of all inventory held is used to arrive at the cost of inventory sold/usedThe average cost of inventory is used to arrive at the cost of closing inventory
  • AVCO can be kept using either the periodic weighted average cost method or
  • The continuous weighted average cost method

Periodic Weighted Average Cost

  • With this valuation method an average cost per unit is calculated based upon the cost of:
    • Opening inventory plus
    • All purchases made during the accounting period
  • With this method of inventory valuation the cost per unit of inventory is calculated at the end of the period when the total quantity and cost of purchases for the period is known

Continuous weighted average cost method

  • Now with this inventory valuation method, an updated average cost per unit is calculated following a purchase of goods
  • The cost of any subsequent sales are accounted for by factoring them into the weighted average cost per unit
  • That is the average cost per unit is changed whenever there  are new purchases
  • This is repeated whenever there are further purchases

NB

  • By their nature weighted average calculations often require a lot of rounding off
  • This might result in rounding errors during calculations in the exam
  • These errors if they do occur can be safely ignored

AVCO Formula

  • The Weighted Average Cost can be calculated using the following formula:
  • \text{Weighted Average Price=}\dfrac{\text{Running total of costs}}{\text{Running total of units}}
  • Running total of costs refers to the sum of the total costs of each batch at the moment when the average is being calculated
  • Running total units refers to the total number of units at each point when the average is being calculated

Example

Itai has closing inventory of 5 units at a cost of $3.50 per unit at 31 December 20X7. During the first week of January 20X8, Itai entered into the following transactions:

  • 2nd January – Bought 5 units at $4.00 per unit
  • 4th January – Bought 5 units at $5.00 per unit
  • 5th January – Sold 7 units at $10 per unit
  • 6th January – Bought 5 units at $5.50 per unit

Required:

  1. Calculate the value of the closing inventory at the end of the first week using AVCO periodic/period-end
  2. Calculate the value of the closing inventory at the end of the first week using AVCO continuous

Solution to Example

DateReceiptsSalesBalance
UnitsUnit Cost ($)Total Cost($)UnitsUnit Cost($)Total Cost($)UnitsUnit Cost ($)Total Cost($)
Op/Bal53.5017.50
Jan 254.0020103.7537.50
Jan 455.0025154.16762.50
Jan 574.16729.16984.16733.331
Jan 655.5027.50134.6860.8131
  • As pointed out above you can safely ignore any rounding off errors that occur
  • The above example uses the continuous method
  • If the periodic average is used the calculations would be:
  • \text{Weighted Average Price=}\dfrac{\text{Running total of costs}}{\text{Running total of units}}
  • \dfrac{\text{5(3.50)+5(4.00)+5(5.00)+5(5.50)}}{\text{5+5+5+5}}
  • \dfrac{\text{17.50+20+25+27.50}}{\text{5+5+5+5}}
  • \dfrac{\text{90}}{\text{20}}
  • 4.50
  • As you can see the periodic period is less complex
  • The resultant amount of $4.50 will be used as the price for issue/cost of sales calculations as well as closing inventory calculations

Advantages of AVCO

  • It is logical and easy to understand
  • Acceptable under IAS 2 and applicable rules and laws of most countries
  • Both issued/sold inventory and closing inventory are priced the same

Disadvantages

  • Inventory and issue/cost of sales prices are not the actual prices at which units of inventory were bought
  • In times of rising prices both inventory and issue/cost of sales prices are usually lower than actual current prices as they are  diluted by lower price points of earlier units

To access more topics go the ZIMSEC Advanced Level Accounting page

To access more topics go to the Cambridge AS/A level page


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