How to Calculate Moving Average Cost & Why This Matters
For businesses moving large volumes of inventory, proper accounting, and management techniques are needed to monitor stock levels and expenses.
One important accounting principle is the moving average cost method, which calculates the average cost per unit after additional products are purchased. This costing method enables businesses to determine their ending inventory cost for each accounting period.
However, there are multiple ways to calculate the value of ending inventory. So why is the moving average cost important?
Moving Average Cost Explained
Many small businesses face the challenge of determining the total value of their perpetual inventory. However, keeping accurate inventory valuation records is essential for proper stock management.
By using the moving average cost method, companies can determine the value of perpetual stock by re-evaluating the unit costs with each purchase. This strategy is related to the first in, first out (FIFO) and last in, first out (LIFO) methods, which calculate the cost of goods sold and ending inventory based on stock movement.
Through finding a balance between the two techniques, the moving average price creates a stable method for financial reporting.
The moving average cost method is best used with a perpetual inventory system, as it changes with every stock purchase. A perpetual inventory system automatically updates whenever real-time data is entered, providing the most accurate values.
Therefore, the method should not be used with periodic tracking systems that only make calculations at the end of accounting cycles. These solutions also do not retain data from each unit required to calculate the average cost.
This method assumes that like goods hold similar or identical market value, making it an efficient way to calculate the cost for businesses that carry similar product lines. However, this is not ideal for companies that offer different types of items or similar goods with varying costs.
How to Calculate the Moving Average Cost
The moving average cost formula enables companies to keep all cost records up to date. Businesses that use the FIFO or LIFO methods may notice that this technique generates a product cost that falls between the other strategies. This is also an excellent alternative for businesses that do not deal with costing layers that are required for other accounting methods.
Businesses can use this formula to calculate the average unit cost of moving material-
Unit Cost = (Total Cost after Purchase) / (Total Quantity after Purchase)
This formula can be further broken down into more manageable steps-
1. New Quantity = Old Quantity + Purchase Quantity
2. New Value = Old Value + Purchase Value
3. New Price = (New Value / New Quantity)
For example, a retailer has 500 units that each cost $2, making the beginning inventory $1000. The business then purchases 100 more products at the beginning of each month, however, the market price increased from $2 to $3. This makes the total amount for the new purchase, $300.
To simplify the equation, the company experienced zero sales during this accounting period. Therefore, the calculations would look like-
New Quantity- 500 + 100 = 600 units
New Value- $1000 + $300 = $1,300
New Price- ($1,300 / 600) = $2.17
This shows that the initial moving average cost of these products increased from $2 to $2.17.
This calculation becomes a bit more intricate when sales are considered. Based on the previous example, let's say that the company sells an average of 60 units at $2 at the beginning of the month before any additional purchases. This makes the COGS $120-
60 Units x $2
This leaves 440 units in stock with a value of $880 since each unit is worth $2.
Later that month, they purchase 100 additional units at $3. This makes the new inventory value $1,100, and the latest moving average cost $2.04.
Inventory Value- 440 x $2 = $880
Purchase Value- 100 x $3 = $300
New Value- $300 + $800 = $1,100
New Quantity- 440 units + 100 units = 540 units
New Moving Average Cost- $1,100 / 540 = $2.04
The retailer then sells an additional 90 items. This leaves 450 units in stock-
New Quantity- 540 - 90
However, since the moving average cost is now $2.04, the COGS is $183.60.
$2.04 x 90 Units
This process would continue with every price increase, additional purchase, and sale, updating the average moving cost so managers can accurately calculate the COGS.
How to Automate Calculations with Inventory Software
Calculating can become cumbersome and complex as inventory quantities increase and businesses expand. Companies can avoid manual calculations by implementing inventory tracking software that automates standard management practices, including updating the moving average cost.
Advanced inventory solutions monitor incoming and outgoing goods in real-time, providing the most accurate values to calculate average costs. Reports are then generated, reflecting sales, inventory, and key financial metrics.
Aside from tracking food costs, inventory control software has many other benefits, including optimizing stock levels. By streamlining routine cycle counts, management can better understand product performance to adjust quantities to promote sales and the bottom line.