The weighted average cost method uses the average of the costs of the goods to assign costs. In other words, weighted average uses the formula: Total cost of items in inventory available for sale divided by total number of units available for sale.
In contrast, FIFO (first in, first out) accounting means that the costs assigned to goods are the costs for the first goods bought. In other words, the company assumes that the first goods sold are the oldest or the first goods bought. On the other hand, LIFO (last in first out) assumes that the last or latest items bought are the first items to be sold.
The costs of goods under weighted average will be between the cost levels determined by FIFO and LIFO. FIFO is preferable in times of rising prices, so that the costs recorded are low and income is higher, while LIFO is preferable in times when tax rates are high because the costs assigned will be higher and income will be lower.
Consider this example for an illustration. Let's say you are a furniture store and you purchase 200 chairs for $10 and then 300 chairs for $20, and at the end of an accounting period you have sold 100 chairs. The weighted average costs, FIFO, and LIFO costs are as follows:
200 chairs @ $10 = $2,000
300 chairs @ $20 = $6,000
Total number of chairs = 500
Weighted Average Cost:
Cost of a chair: $8,000 divided by 500 = $16/chair
Cost of Goods Sold: $16 x 100 = $1,600
Remaining Inventory: $16 x 400 = $6,400
Cost of Goods Sold: 100 chairs sold x $10 = $1,000
Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) = $7,000
Cost of Goods Sold: 100 chairs sold x $20 = $2,000
Remaining Inventory: (200 chairs x $10) + (200 chairs x $20) = $6,000
For more on the analysis of Financial Statements, take a look at our tutorial: Fundamental Analysis.
This question was answered by Chizoba Morah.
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