There is One More Thing you Need to Know about Cost Price
“It’s All about Cost Management,” Said Ms. Retailer
It was Mr. Retailer’s first moment of confusion. He started grinding his teeth in exasperation, and then remembered his dentist’s advice: “you will chip off all your teeth enamel if don’t check this habit of yours.”
He took three deep breaths and tried to think of the ways to get out of the dilemma. Then he remembered. “Ms. Retailer! Sure she can help me. She is such a smart and successful woman,” he said to himself and dialed her number for an appointment.
It was in Ms. Retailer’s plush office that he learned about cost management.
He explained his problem:
“I am quite good at inventory management, at least till now I thought I was! Recently there have fluctuations in the cost price of one of my inventory items. Let me explain:
I purchased 50 items from a wholesaler at 100 per item. On the 20th of October the total cost my inventory was thus:
On 1st November I had sold 30 items meaning my inventory stock on 1st November was 20 items.
On 2nd November I purchased 60 pieces of the same item at 120 per item thus bringing my inventory to: 20 (old stock) + 60 (new stock) = 80 items.
Now the problem is that 20 pieces in my inventory cost 100 per pieces and 60 pieces cost 120 per piece.
I am finding it difficult to manage the cost price. At what price should I sell? Should I sell the same item at different prices? Not possible! How can I keep track of my profits if I charge the same retail price for the items that have different cost prices?
Ms. Retailer who had been listening intently-she was a good listener-nodded sympathetically, and said, “It’s simple. You need to calculate weighted Average Cost.”
“Weighted Average Cost?”
“Yes. Let me explain,” she said.
“The cost price of various goods and services is variable and can change periodically. Depending on the nature of the business, such changes can be occasional or frequent. Cost price management is important for three critical reasons:
- To reflect accurate profitability.
- To give a correct estimate of your inventory value.
- To provide an accurate benchmark for selling obsolete inventory.
Calculating weighted average cost is the way to successful cost management. For this you need to consider the old and new costs plus old and new stocks and then arrive at an average cost. This cost is called weighted average cost and is calculated by this formula:
(Old stock*old average cost +new stock*new cost)/ (Old stock + new stock)
Let’s apply this formula to your example:
(20 *100 + 60 * 120) / (20 + 60) = (2000 + 7200) / 80 =
9200/80 = 115
Thus the new weighted average cost price will be 115.
Ms. Retailer then took a marker and explained weighted cost thus on the white board:
“Here is an example of a weighted average cost price of a product over a period of 5 months:
Now stop grinding your teeth and don’t look so helpless. Sip coffee and try to get a good RMS system that can automatically calculate weighted average cost.”
“Oh, yes. I definitely need a good RMS. Thank you; you are such a smart woman.”
“It is nice to meet a man who doesn’t find it difficult to admit that women can be smart,” she teased him.
“Designing and selling women apparel line has made me a feminist. You can’t really be good in this business without having egalitarian values,” he smiled.
“Right you are, Mr. Retailer. You will go a long way with values such as these.”