The Weighted-Average Cost (WAC) method is an accounting approach used for inventory valuation. Imagine you're a baker who buys flour throughout the month at different prices. At the end of the month, instead of trying to figure out if the bread you sold was made from the cheap flour you bought on the 1st or the pricier flour from the 15th, you simply calculate an average price for all the flour in your storeroom. This blended, or weighted-average, cost is then used to determine the value of the flour you used (your Cost of Goods Sold (COGS)) and the value of the flour you have left (your ending inventory). It smooths out price fluctuations and is particularly useful for businesses dealing with identical items that are difficult to track individually, like grains, fuel, or milk. This method provides a middle-of-the-road valuation that is logical, consistent, and less complex than other inventory costing methods.
The logic behind WAC is straightforward: it averages out the cost of all goods available for sale during a period. By doing this, it assigns the same cost to every single unit, whether it's sitting on the shelf or has been sold to a customer.
The calculation is as simple as it sounds. You find the average cost per unit by taking the total cost of all your inventory and dividing it by the total number of units. Weighted-Average Cost Per Unit = Total Cost of Goods Available for Sale / Total Number of Units Available for Sale Where:
Let’s say “Capipedia Gadgets Inc.” sells a single type of widget. Their purchase history for the quarter looks like this:
Here’s how to calculate the WAC:
The inventory method a company chooses can significantly change its financial statements. WAC is often compared with two other popular methods: FIFO (First-In, First-Out) and LIFO (Last-In, First-Out).
FIFO assumes the first units purchased are the first ones sold. In our widget example, under FIFO, the 300 units sold would be costed using the oldest prices first (100 @ $10 and 200 @ $11). In a period of rising prices (inflation), this leads to a lower COGS, higher reported profit, and a higher tax bill.
LIFO assumes the last units purchased are the first ones sold. In our example, the 300 units sold would be costed using the newest prices first (150 @ $12 and 150 @ $11). During inflation, this results in a higher COGS, lower reported profit, and a lower tax bill. Note: LIFO is permitted under U.S. GAAP but is banned under IFRS (International Financial Reporting Standards), making it rare outside the United States.
The WAC method is the great compromiser. Its calculated COGS and net income will almost always fall between the figures produced by FIFO and LIFO. This makes a company's financial results less sensitive to short-term price swings and provides a more blended, stable view of profitability.
For a value investing practitioner, understanding a company's inventory method is more than an academic exercise—it's a peek into the quality of its reported earnings.