Net Income Using the Weighted-Average Cost-Flow Assumption
Weighted-average inventory accounting assumes the average cost per unit of inventory is the same as the actual cost of goods sold. Cost-flow refers to business expenses deducted from income. Businesses use weight-average cost-flow assumptions when they cannot easily keep track of the average price of inventory due to irregular recordkeeping of inventory costs.
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Methods
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Since prices on a product that a business owner purchases from a vendor can increase or decrease over time, he must decide the cost of the product that the customer purchased. For example, a business owner who has two copies of the same toy that cost him $10 and $12 each must decide whether he should include $10 or $12 as the cost of goods sold when a customer buys a toy. He may use the weighted-average of the total quantity of product in stock to determine the price he paid for it. In this case, he would count the cost of the sold toy as $11 for accounting purposes.
Calculations
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To determine gross income, business owners using this assumption will subtract from their total revenue generated from sales the weighted-average of the cost of goods sold. To determine net income, they will then subtract other cost-flows, such as payroll, marketing, depreciation and interest expense from gross income. Governments use net income to determine the taxable basis of businesses.
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Considerations
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Using a weighted-inventory assumption lowers the net income of a business in an inflationary environment and increases it during a deflationary environment compared to other accounting methods. With deflation, consumer demand for products drops, causing vendors to lower the sale prices of their inventory. With inflation, newly obtained products cost the business owner more to purchase than older inventory over a multiyear period.
Comparison
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Weighted-average cost-flow accounting differs from first-in first-out, or FIFO, and last-in first-out, or LIFO, accounting methods. With FIFO, businesses will count the cost of the first product purchased as the cost basis of the sale. With LIFO, businesses will count the cost of the last product they purchased as the first product sold. Since governments typically pursue an inflationary policy, LIFO lowers net income the most and FIFO increases net income the most. Since weighted-average accounting results in a net income between FIFO and LIFO, business owners receive a hedge against excess taxation in either an inflationary or deflationary economic climate.
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