To run your business effectively, you should always have on hand the items that your customers are demanding. But it’s not financially feasible (and often, not even possible) to keep high numbers of every single item that you offer within your inventory. So, it’s the job of a business owner to determine what constitutes a healthy inventory level to best serve customers while keeping your bottom line low.
To figure out the “sweet spot” for your inventory levels, there are tons of computations and accounting principles that you can apply to your business. One of the most common and perhaps most important aspects here is computing your average costs. Further, one of the ways you can do this is by using a figure called the moving average cost. Here, we’ll explain what the moving average cost is, how you can calculate it, and why it’s important to your business.
Moving Average Cost Definition
“Moving average cost” is sometimes referred to as the “moving average inventory method.” Accountingtools.com provides the following definition: “Under the moving average inventory method, the average cost of each inventory item in stock is recalculated after every inventory purchase. This method tends to yield inventory valuations and cost of goods sold results that are in between those derived under the first-in, first-out (FIFO) method and the last in, first out (LIFO) method. This averaging approach yields a safe and conservative financial result.”
In layman’s terms, the average unit cost of an item is recalculated every time an item is purchased. This process is ongoing since there are constantly purchases and sales going on throughout the year, and it provides a safer estimate of cost as opposed to the FIFO or LIFO methods.
Calculating Moving Average Cost
Many businesses turn to a program or calculator that can automatically come up with your moving average cost. The formula behind these programs is as follows:
Unit Cost = (Total Cost After Purchase) / (Total Quantity After Purchase)
From there, we can break down the formula even further. You would start by adding your old quantity and your purchase quantity to come up with a figure for your new quantity. Then, in the same fashion, you would add your old value and your purchase value to come up with your new value. Finally, calculating the new value divided by the new quantity would give you the new price.
Example;
Let’s say that you run a candle company and you want to figure out your moving average cost. You currently have 300 units that each cost $5, which equals a beginning inventory of $1,500. Then, you purchase 100 extra candles at the start of the month, but when you make your purchase, you find that the market price has increased from $5 to $8. So, your purchase of 100 candles at $8 apiece comes out to a new purchase amount of $800.
For the purposes of this example, we’ll say that you had no sales for this accounting period. Your new quantity would come out to 400 (300 + 100), your new value would come out to $2,300 ($1,500 + $800), and your new price would come out to $5.75 ($2,300/400). So, in this scenario, the moving average cost of your candles increased from $5 to $5.75.
As we mentioned, this example maintained that your company had no sales during this time. However, if we do add sales into the equation, it gets a bit more complicated. Let’s continue with the same example.
Let’s say that, before you make any additional purchases for your company, you sell an average of 40 units at $5 each, leading to a cost of goods sold (COGS) of $200. The 40 units that you sold come out of your original stock of 300, leaving you with 260 units in stock with a value of $1,300 (since each unit is worth $5).
Later, you make your purchase of 100 extra units at $8 each. This purchase value comes out to $800, and when you add it to your previous inventory value of $1,300, you get a new value of $2,100. You also have a new quantity: you’ve purchased 100 new units and already had 260 units in stock, totaling 360 units. Therefore, your new moving average cost is calculated as follows:
$2,100 / 360 = $5.83.
But since moving average cost is a perpetual process, it doesn’t stop there. Let’s say you go on to sell an additional 50 items, leaving 310 units in stock as your new quantity. We’ve come up with a new moving average cost of $5.83, so when we multiply that by our quantity of 50 items that we’ve just sold, it comes out to a new COGS of $291.50. Every time there’s a price increase, extra purchase, or sale, the average moving cost would be updated, allowing you to more accurately calculate your COGS.
Why is Moving Average Cost Important?
With all of that said and done, why is it even important to calculate your moving average cost? There are a few reasons why this figure is important for your business. First, one of the main focuses of your business is to sell the products that you have on hand and reduce your stock. Counting items individually can be quite easy, but if you sell items in bulk, the process gets much harder. For instance, it would be easy to calculate how many candles do you have on hand, but if you sell gasoline, it can be a lot harder to keep an accurate inventory.
Things that are sold in bulk make it virtually impossible to differentiate old and new stock. However, new deliveries often have different prices from old deliveries, so without calculating your moving average cost, you may not have an accurate picture of your cost of goods sold.
Being able to accurately determine your moving average cost is vital when it comes to sales and inventory reports. The circumstances of every sale change depending on how many items you have in stock and how much it costs you to get them. Without an accurate picture at all times, your sales and inventory reports might be off, giving you an inaccurate picture of your overall financial standing.
Your moving average cost can be used when you are computing your net sales and comparing it with your cost of goods sold, giving you a more accurate gross profit computation. You can also use it when you’re recording your inventory to help you compute your assets. Though the process of determining your moving average cost might sound complicated, it’s actually an important step to determining the most current price of any given item and helping your business stay in a good financial position at all times.
Automate Your Calculations
As you can see from our example above, calculating your moving average cost manually will prove next to impossible, especially as your business keeps growing. It can be incredibly time-consuming and complicated, and with so many numbers involved and as often as you will have to make this calculation, the potential for human error is incredibly high. One misstep could cause your entire calculation to be off, and if the error is not identified until you’ve already made several more purchases, there’s no telling how much time you have to spend going back and correcting the mistake.
Luckily, there are many online calculators that can handle all of these numbers for you. Not only are they the most accurate way to ensure that you’ve got the right moving average cost, but they will save you unimaginable amounts of time and money. Instead of having to slave away over the numbers after every purchase, you can simply open up your program to see what your moving average cost or cost of goods sold is at any given time.
Using an inventory tracking software can provide many more benefits on top of calculating your moving average cost. The software can help you monitor your inventory as it comes in and goes out in real-time, generate accurate reports that can help you forecast future demand, and optimize your stock levels to ensure that you never have too much or too little of any certain item.
Level Up Your Business With DEAR Systems
Technologies like inventory tracking software can be huge assets to the daily performance and future growth of your business. To ensure that you always have the most accurate information and can access it all in one convenient place, consider investing in a cloud ERP software like that available from DEAR Systems. We have designed our software to help you with virtually every aspect of your business, from inventory management and manufacturing to sales, accounting, purchasing, e-commerce, and more.
Not only will you have the benefits of our software, but you’ll also have our dedicated team of experts by your side every step of the way. We can help you customize your software to best meet your needs, integrate with other programs that you’re already using, and always ensure that your business is running as smoothly and efficiently as possible.
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