A perpetual inventory system involves recording every receipt and issue of stock that occurs so that there is a continuous record of the balance of each stock item on hand. Under a perpetual inventory system that uses the weighted average cost basis stock issues and remaining stock are priced at the average unit cost.
Perpetual Inventory Systems
Under these systems a stock account is kept for each item of stock. Goods purchased are recorded at the purchase price and goods issued are recorded at a price or prices that depend on the costing method used. These types of systems are increasingly being used in retail and warehouse operations.
The most common cost base methods in use are:
- First In First Out (FIFO);
- Last In First out (LIFO);
- Replacement Cost; and
- Weighted Average Cost.
And its the latter of these four that we are going to be looking at today.
Weighted Average Cost Basis
The weighted average cost method calculates a weighted average price for all units of stock within that class. As we mentioned in the introduction, this system applies the weighted average to both units as they are issued and their cost on hand at a set period of time, for example for year-end reporting.
As stock units are purchased and then sold or consumed this method recalculates a new cost figure and so provides a continuous weighted figure to be used. This has the advantage of smoothing out fluctuations in price and is an easier method to understand when compared with say LIFO and FIFO. The main reason being there is no need to maintain separate cost identification for each unit of stock.
The disadvantage of course to this system then of course is that the price being used is most likely the same as the actual costs being incurred at that point in time or material changes over short periods of time.
So that is some of the back ground to a weighted average perpetual inventory system. Now lets work through an example and see how it works along with the accounting entries required.
ABC Ltd for the month of March 20XX had the following data available. We have been asked to prepare a trading account for the month ended 31 March 20XX.
The two tables below display the purchase and sales data respectively for the month. The tables contain the date of the transaction, the number of units transacted, the unit price at that date and the total cost or sale price. The total purchases costs of $582,500 and the total sales of $1,002,500 will be both be used in the trading account.
Now we have the purchase and sales data we are able to to construct the weighted average cost table, which we have set out below. The purpose of this table is so we can obtain the closing stock unit cost for 31 March, which we are going to need in for our trading account.
You can see in the table that every time there is a purchase or a sale the price per unit changes based on the average at that point. So for example, on 1 March we have the opening stock figure of 2,500 units with a weighted average price of $28. This gives us a total price of $70,000. These figures would have come from the February 20XX stock data. Then on 2 March there is a purchase of another 2,500 units at a unit price of $32, which equals $80,000 in total. This leads us to having a total stock on hand of 5,000 units, with a total value of $150,000. Which means the average unit price is:
$150,000 / 5,000 units = $30 per unit price
And this approach is carried on all the way down, including sales. So on 5 March there is a sale of 3,100 units with a weighted average price on that day of $30, obtained from the row above, and so leading to a total cost of $93,000 for those units. As we have used the average unit cost of $30 in that transaction the results new average price is of course still $30.
So you can see the unit price is always only moved by the purchase transactions, with the sales transactions picking up whatever the running weighted average price is at that point in time.
We now have a closing total of 4,500 units and at a total $179,238 means we have a weighted average price per unit of $39. The opening total of $70,000 and the closing total of $174,238 are carried down into the trading account.
And this is our final step, putting together the trading account for the month of March 20XX. Below we have ABC’s account, with sales (from the sales table), opening stock (from the weighed average table), purchases (from the purchases table) and closing stock (from the weighted average table) to provide us with the gross profit calculation.
We trust you have found this exercise useful in understanding how a weighted average perpetual inventory system works and how it feeds into the financial accounts. We always welcome your comments or questions. We also have an extensive database of questions and answers that you might find useful; and it’s a great place to help others who have raised questions there.