Weighted-Average Cost (WAC)

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:

• Total Cost of Goods Available for Sale is the value of your beginning inventory plus the cost of all new purchases during the period.
• Total Number of Units Available for Sale is the number of units in your beginning inventory plus all the new units you purchased.

Let’s say “Capipedia Gadgets Inc.” sells a single type of widget. Their purchase history for the quarter looks like this:

• January: Bought 100 widgets @ $10 each (Total cost: $1,000)
• February: Bought 200 widgets @ $11 each (Total cost: $2,200)
• March: Bought 150 widgets @ $12 each (Total cost: $1,800)

Here’s how to calculate the WAC:

1. Step 1: Find the total cost and total units.
   • Total Cost = $1,000 + $2,200 + $1,800 = $5,000
   • Total Units = 100 + 200 + 150 = 450 units
2. Step 2: Calculate the weighted-average cost per unit.
   • WAC per unit = $5,000 / 450 units = $11.11 (approximately)
3. Step 3: Apply the WAC.
   • If Capipedia Gadgets sold 300 widgets during the quarter, their COGS would be: 300 units x $11.11 = $3,333.
   • Their ending inventory (450 - 300 = 150 units) would be valued on the balance sheet at: 150 units x $11.11 = $1,666.50.

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.

• Know What You're Comparing: When comparing two companies in the same industry, check their inventory method. A company using FIFO might look more profitable than a competitor using WAC during inflationary times, but this difference is purely due to accounting choices, not superior business operations.
• A Sign of Simplicity: WAC is logical and difficult to manipulate. For businesses with homogenous products (e.g., oil companies, chemical producers), it is often the most sensible choice. It prevents management from cherry-picking costs to artificially inflate profits in a given quarter.
• Focus on Cash Flow: Accounting methods can muddy the waters of reported profit (earnings per share (EPS)). As an investor, always bring your focus back to the underlying cash flow generation of the business. The WAC method, by smoothing costs, can sometimes provide a COGS figure that more closely reflects the true economic reality over a full cycle. Always analyze the full picture, including the value of assets on the balance sheet and the notes to the financial statements, to understand the real story.