Adjusted inventory average cost

What Is Adjusted Inventory Average Cost?

Adjusted Inventory Average Cost represents the final valuation of a company's inventory after applying the weighted-average cost method and then incorporating any necessary adjustments mandated by prevailing accounting standards). This concept falls under the broader financial category of inventory valuation, a critical component of a business's financial statements. The weighted-average cost method itself smooths out price fluctuations by calculating a single average unit cost for all available inventory. The "adjusted" aspect accounts for situations where the market value of inventory declines below its calculated cost, requiring a write-down to reflect a more conservative and realistic Balance Sheet value.

History and Origin

The evolution of inventory costing methods, including various average cost approaches, has been intertwined with the development of accounting principles aimed at accurately reflecting a company's financial position and performance. Historically, businesses have sought methods to systematically assign costs to products sold and those remaining in inventory. The average cost method emerged as a pragmatic approach, particularly useful for homogeneous products where individual unit tracking is impractical.

A significant development in how inventory costs are adjusted under U.S. GAAP occurred with the issuance of Accounting Standards Update (ASU) 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory, by the FASB Accounting Standards Update 2015-11. Effective for fiscal years beginning after December 15, 2016, this update changed the subsequent measurement principle for inventory from the "lower of cost or market" to the "lower of cost and Net Realizable Value" (LCNRV) for entities using methods other than Last-In, First-Out (LIFO)) or the retail inventory method.²⁵, ²⁶, ²⁷ This simplification aimed to reduce complexity and enhance comparability between U.S. GAAP and International Financial Reporting Standards (IFRS).²³, ²⁴

Key Takeaways

• Adjusted Inventory Average Cost provides a more conservative and realistic valuation of inventory on the balance sheet.
• It begins with the weighted-average cost method to determine the average cost of all inventory units available for sale.
• The "adjustment" primarily refers to applying the lower of cost and net realizable value (LCNRV) rule, which necessitates writing down inventory if its selling price, less costs to complete and sell, falls below its average cost.
• This valuation method impacts a company's reported Cost of Goods Sold (COGS) and, consequently, its Gross Margin and Taxable Income.
• Adjusted Inventory Average Cost aligns with accounting conservatism, ensuring assets are not overstated.

Formula and Calculation

The calculation of Adjusted Inventory Average Cost involves two primary steps: first, determining the weighted-average cost per unit, and second, applying the lower of cost and net realizable value (LCNRV) rule if required.

The weighted-average cost per unit is calculated as follows:

Where:

• Total Cost of Goods Available for Sale includes the cost of beginning inventory plus the cost of all purchases during the period.
• Total Units Available for Sale includes beginning inventory units plus all units purchased during the period.

After calculating the weighted-average cost per unit and the total cost of ending inventory, the Net Realizable Value (NRV) of the inventory must be determined. NRV is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.²¹, ²²

The final Adjusted Inventory Average Cost is the lower of:

1. The inventory's cost calculated using the weighted-average method.
2. The inventory's Net Realizable Value.

If the NRV is lower than the weighted-average cost, an Asset Impairment write-down is recorded.

Interpreting the Adjusted Inventory Average Cost

Interpreting the Adjusted Inventory Average Cost involves understanding its implications for a company's financial health. When this figure is significantly lower than the historical weighted-average cost, it signals that the market value of the inventory has declined. This could be due to factors such as obsolescence, damage, or a drop in demand. Such a reduction indicates that the company will realize less revenue from selling the inventory than its original cost, impacting future profitability.

A lower Adjusted Inventory Average Cost directly translates to a higher Cost of Goods Sold (COGS) and, consequently, a lower reported Gross Margin and net income in the period the adjustment is made. This conservative approach is mandated by Generally Accepted Accounting Principles (GAAP)) to prevent overstating assets on the Balance Sheet and to provide a more realistic portrayal of a company's financial position to investors and creditors.

Hypothetical Example

Consider "TechGadget Inc.," a retailer of electronic components. On January 1, they had 100 units of a specific circuit board in inventory valued at $10 per unit.

During the first quarter:

• January 15: Purchased 200 units at $12 per unit.
• February 10: Purchased 150 units at $13 per unit.
• March 5: Sold 300 units.

Step 1: Calculate Total Cost and Units Available for Sale:

• Beginning Inventory: 100 units * $10 = $1,000
• January Purchase: 200 units * $12 = $2,400
• February Purchase: 150 units * $13 = $1,950

Total Units Available for Sale = 100 + 200 + 150 = 450 units
Total Cost of Goods Available for Sale = $1,000 + $2,400 + $1,950 = $5,350

Step 2: Calculate Weighted-Average Cost Per Unit:
Weighted-Average Cost Per Unit = $5,350 / 450 units = $11.89 per unit (rounded)

Step 3: Calculate Cost of Goods Sold and Ending Inventory:

• Units Sold = 300 units
• Cost of Goods Sold = 300 units * $11.89 = $3,567
• Ending Inventory Units = 450 - 300 = 150 units
• Ending Inventory (at weighted-average cost) = 150 units * $11.89 = $1,783.50

Step 4: Apply Adjustment (Lower of Cost and Net Realizable Value):
At the end of the quarter, due to a new model release, the estimated Net Realizable Value for the remaining 150 circuit boards is determined to be $11.00 per unit.

• Ending Inventory at Weighted-Average Cost = $1,783.50
• Ending Inventory at NRV = 150 units * $11.00 = $1,650

Since the NRV ($1,650) is lower than the weighted-average cost ($1,783.50), TechGadget Inc. must write down its inventory.

Adjusted Inventory Average Cost = $1,650

The company would record an inventory write-down of $133.50 ($1,783.50 - $1,650), reducing the value of its inventory on the Balance Sheet to the Adjusted Inventory Average Cost of $1,650. This adjustment impacts the Income Statement by increasing Cost of Goods Sold by the write-down amount.

Practical Applications

Adjusted Inventory Average Cost is a fundamental concept in Cost Accounting with several practical applications across various business functions. It is crucial for financial reporting, ensuring that a company's inventory is presented at a value that accurately reflects its economic worth, especially when market conditions change. This valuation method directly influences the Balance Sheet by determining the carrying amount of inventory and impacts the Income Statement through its effect on the Cost of Goods Sold.

For tax purposes, the Internal Revenue Service (IRS) permits the use of the weighted-average cost method, among others, for inventory valuation.¹⁸, ¹⁹, ²⁰ Companies must consistently apply their chosen method and obtain approval from the IRS for any changes.¹⁶, ¹⁷ The IRS Lower of Cost or Market (LCM) rule also plays a role, requiring inventory to be valued at the lower of its cost or market value.¹⁵

Furthermore, understanding Adjusted Inventory Average Cost is vital for effective Supply Chain management. It helps businesses evaluate inventory turnover, identify slow-moving or obsolete stock, and make informed decisions regarding purchasing and pricing strategies. Companies with perishable goods, technology products with short life cycles, or commodity-based inventory are particularly susceptible to Asset Impairment due to declining values, making the "adjusted" aspect of this costing method highly relevant.¹⁴

Limitations and Criticisms

While the Adjusted Inventory Average Cost method offers simplicity and smoothing of price fluctuations, it also has limitations. A primary criticism is that the averaging process can obscure the impact of recent cost changes, potentially leading to a mismatch between current costs and revenues, especially during periods of rapid inflation or deflation.¹¹, ¹², ¹³ This can result in reported financial figures that do not fully reflect the most current economic realities.

Another limitation arises from the potential for income manipulation, albeit less pronounced than with some other methods. While the First-In, First-Out (FIFO)) method generally prevents manipulation by always valuing sold units at the oldest costs, the averaging nature of the weighted-average method can still be influenced by the timing of large purchases or the decision to purchase or not purchase goods near the end of an accounting period.¹⁰

Furthermore, the "adjustment" component, while necessary for compliance with accounting standards like the lower of cost and net realizable value (LCNRV) rule, relies on estimations of future selling prices and costs. These estimations can introduce subjectivity into the financial reporting process. While Generally Accepted Accounting Principles (GAAP)) provide guidelines, the application of judgment in determining Net Realizable Value can vary. For instance, the SEC staff has historically inquired about companies' policies and estimates related to inventory valuation.⁹ Academic research has also examined the implications of differing inventory costing methods, particularly in the context of convergence between U.S. GAAP and IFRS.⁸

Adjusted Inventory Average Cost vs. Weighted Average Cost

The distinction between Adjusted Inventory Average Cost and Weighted Average Cost lies in the application of subsequent valuation adjustments.

The Weighted Average Cost method is one of several cost flow assumptions used to determine the cost of inventory and Cost of Goods Sold. It involves dividing the total cost of goods available for sale by the total units available for sale. This method is praised for its simplicity and ability to smooth out price fluctuations, providing a middle ground between FIFO) and LIFO).⁶, ⁷

However, the accounting standards (specifically U.S. GAAP for companies not using LIFO) require that inventory be reported at the lower of its cost or its Net Realizable Value (NRV).⁴, ⁵ Therefore, after calculating the initial inventory value using the weighted-average cost method, a company must assess if the NRV is lower. If it is, the inventory value is "adjusted" downward to the NRV. Thus, Adjusted Inventory Average Cost refers to this final, potentially adjusted, reported value.

FAQs

What does "adjusted" mean in Adjusted Inventory Average Cost?

The "adjusted" part refers to applying a necessary accounting principle, primarily the "lower of cost and Net Realizable Value" (LCNRV) rule. This means that if the estimated selling price of your inventory (minus costs to sell) falls below its calculated average cost, the inventory's value on the Balance Sheet must be reduced to that lower net realizable value.

Why is this adjustment necessary?

The adjustment is necessary to adhere to the accounting principle of conservatism, which dictates that assets should not be overstated. If the market value of inventory declines below its original cost, it reflects a loss in value that should be recognized in the current period. This provides a more accurate picture of a company's financial health.

How does it affect a company's profitability?

When the inventory value is adjusted downward, it results in an increase to the Cost of Goods Sold (COGS) in the period the adjustment occurs. A higher COGS, in turn, leads to a lower reported Gross Margin and net income for that period.

Is Adjusted Inventory Average Cost allowed by the IRS?

Yes, the underlying weighted-average cost method is an acceptable method for valuing inventory for tax purposes by the IRS. The IRS also generally requires inventory to be valued at the lower of cost or market. Businesses must consistently apply their chosen inventory method.¹, ², ³

What kind of businesses typically use the Adjusted Inventory Average Cost method?

Businesses that deal with a large volume of homogeneous, undifferentiated products often find the weighted-average cost method, and consequently the Adjusted Inventory Average Cost, practical. This can include industries like retail, manufacturing of standard goods, or businesses dealing with commodities where specific tracking of each item's cost is not feasible or necessary.