Inventory Management 101: What Is Moving Average Cost And Why Is It Vital For Any Business?
For any business that sells goods to customers, the company needs to maintain a healthy inventory to be able to serve the requirements of its customers. Numerous types of computational methods and accounting principles are utilized so that the company can keep track of goods that are being sold and the ones that they have in stock. And one of these computational methods includes the moving average cost.
So, you might wonder that - what is moving average cost? Well, that’s what we’re going to discuss in this comprehensive guide. So, without further ado, let’s get down to the topic at hand.
What Do You Mean By Moving Average Cost?
Moving average cost otherwise referred to as the moving average inventory method, is an inventory costing process where after acquisition or purchase of each good, the average cost of the items is recomputed. The computation is carried out by adding the cost of the goods that are currently present in the inventory along with the newly acquired goods. Once the cost is added, the same is then divided by the total number of items.
Thus, when it comes to customer order fulfilment & inventory management, the moving average cost is a method to calculate the cost of the ending inventory. Moreover, you must learn that this a perpetual procedure, which means that purchases & sales will take place throughout the entirety of the year. As per reports, this type of inventory costing process is better than utilising methods such as FIFO (First In First Out) or LIFO (Last In First Out).
How Can You Calculate Moving Average Cost?
Most businesses out there generally use a calculator or program that can automatically calculate the total moving average cost. No manual calculation is performed in this scenario, at least in the modern-day & age. However, the calculation formula is given as below:
Unit Cost = Total Cost After Purchase / Total Number Of Units After Purchase
To explain the process, you need to first add the cost of the previous inventory items along with the cost of the new inventory that is purchased. The total value obtained will then be divided by the total quantity of items. The divided result will provide you with the unit cost of each good in your inventory. The process will be followed every time a purchase will be made.
For understanding the above formula in a much better manner, we are sharing an example:
Let's say, you have 100 items in your current inventory where the cost of each item is at $5. That means the total cost of your inventory is $500. Now, you purchase 100 more items, but now the market price has increased to $10. That means you had to spend $1,000 to obtain the extra 100 unit of goods. When you add both the quantities together, you'll have 200 units, with the cost being $1,500 ($1,000 + $500). Now, when you divide $1,500 with 200 units, the per-unit price comes to $7.5.
Thus, the moving average cost of your items increased from $5 to $7.5.
The Importance Of Moving Average Cost
According to professional inventory management services, one of the main reasons why this moving average cost is used is because to accurately measure the selling price of an item or good.
Separating old stocks from new ones will become difficult especially for companies who make purchases frequently and the demand for the product is high. However, with the help of moving average cost, the new cost is updated without any delay.