zenduck.me: Moving average inventory method definition

Under the moving average inventory method, the average cost of each inventory item in stock is re-calculated after every inventory purchase. This method tends to yield inventory valuations and cost of goods sold results that are in-between those derived under the first in, first out (FIFO) method and the last in, first out (LIFO) method. This averaging approach yields a safe and conservative financial result.

The calculation is the total cost of the items purchased divided by the number of items in stock. The cost of ending inventory and the cost of goods sold are then set at this average cost. No cost layering is needed, as is required for the FIFO and LIFO methods.

Since the moving average cost changes whenever there is a new purchase, the method can only be used with a perpetual inventory tracking system; such a system keeps up-to-date records of inventory balances. You cannot use the moving average inventory method with a periodic inventory system, since such a system only accumulates information at the end of each accounting period, and does not maintain records at the individual unit level.

Also, when inventory valuations are derived using a computer system, the computer makes it relatively easy to continually adjust inventory valuations with this method. Conversely, it can be quite difficult to use the moving average method when inventory records are being maintained manually, since the clerical staff would be overwhelmed by the volume of required calculations.

Example of the Moving Average Inventory Method

Example #1: ABC International has 1,000 green widgets in stock as of the beginning of April, at a cost per unit of $5. Thus, the beginning inventory balance of green widgets in April is $5,000. ABC then purchases 250 additional green widgets on April 10 for $6 each (total purchase of $1,500), and another 750 green widgets on April 20 for $7 each (total purchase of $5,250). In the absence of any sales, this means that the moving average cost per unit at the end of April would be $5.88, which is calculated as a total cost of $11,750 ($5,000 beginning balance + $1,500 purchase + $5,250 purchase), divided by the total on-hand unit count of 2,000 green widgets (1,000 beginning balance + 250 units purchased + 750 units purchased). Thus, the moving average cost of the green widgets was $5 per unit at the beginning of the month, and $5.88 at the end of the month.

We will repeat the example, but now include several sales. Remember that we recalculate the moving average after every transaction.

Example #2: ABC International has 1,000 green widgets in stock as of the beginning of April, at a cost per unit of $5. It sells 250 of these units on April 5, and records a charge to the cost of goods sold of $1,250, which is calculated as 250 units x $5 per unit. This means there are now 750 units remaining in stock, at a cost per unit of $5 and a total cost of $3,750.

ABC then purchases 250 additional green widgets on April 10 for $6 each (total purchase of $1,500). The moving average cost is now $5.25, which is calculated as a total cost of $5,250 divided by the 1,000 units still on hand.

ABC then sells 200 units on April 12, and records a charge to the cost of goods sold of $1,050, which is calculated as 200 units x $5.25 per unit. This means there are now 800 units remaining in stock, at a cost per unit of $5.25 and a total cost of $4,200.

Finally, ABC buys an additional 750 green widgets on April 20 for $7 each (total purchase of $5,250). At the end of the month, the moving average cost per unit is $6.10, which is calculated as total costs of $4,200 + $5,250, divided by total remaining units of 800 + 750.

Thus, in the second example, ABC International begins the month with a $5,000 beginning balance of green widgets at a cost of $5 each, sells 250 units at a cost of $5 on April 5, revises its unit cost to $5.25 after a purchase on April 10, sells 200 units at a cost of $5.25 on April 12, and finally revises its unit cost to $6.10 after a purchase on April 20. You can see that the cost per unit changes following an inventory purchase, but not after an inventory sale.