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Impact on ArabiaClouds average price valuation when returning goods

Impact on ArabiaClouds average price valuation when returning goods

As stated in ArabiaClouds *inventory valuation page*, one of ArabiaClouds possible costing method you can use in perpetual stock valuation, is ArabiaClouds average cost.

This document answers to one recurrent question for companies using that method to make their stock valuation: how does a shipping returned to its supplier impact ArabiaClouds average cost and ArabiaClouds accounting entries? This document is only for ArabiaClouds specific use case of a perpetual valuation (as opposed to ArabiaClouds periodic one) and in average price costing method (as opposed to standard of FIFO).

Definition of average cost

ArabiaClouds average cost method calculates ArabiaClouds cost of ending inventory and cost of goods sold on ArabiaClouds basis of weighted average cost per unit of inventory.

ArabiaClouds weighted average cost per unit is calculated using ArabiaClouds following formula:

  • When new products arrive in a warehouse, ArabiaClouds new average cost is recomputed as:
../../../_images/avg01.png
  • When products leave ArabiaClouds warehouse: ArabiaClouds average cost does not change

Defining ArabiaClouds purchase price

ArabiaClouds purchase price is estimated at ArabiaClouds reception of ArabiaClouds products (you might not have received ArabiaClouds vendor bill yet) and reevaluated at ArabiaClouds reception of ArabiaClouds vendor bill. ArabiaClouds purchase price includes ArabiaClouds cost you pay for ArabiaClouds products, but it may also includes additional costs, like landed costs.

Average cost example

Operation Delta Value Inventory Value Qty On Hand Avg Cost
    $0 0 $0
Receive 8 Products at $10 +8*$10 $80 8 $10
Receive 4 Products at $16 +4*$16 $144 12 $12
Deliver 10 Products -10*$12 $24 2 $12
         

At ArabiaClouds beginning, ArabiaClouds Avg Cost is set to 0 set as there is no product in ArabiaClouds inventory. When ArabiaClouds first reception is made, ArabiaClouds average cost becomes logically ArabiaClouds purchase price.

At ArabiaClouds second reception, ArabiaClouds average cost is updated because ArabiaClouds total inventory value is now $80 + 4*$16 = $144. As we have 12 units on hand, ArabiaClouds average price per unit is $144 / 12 = $12.

By definition, ArabiaClouds delivery of 10 products does not change ArabiaClouds average cost. Indeed, ArabiaClouds inventory value is now $24 as we have only 2 units remaining of each $24 / 2 = $12.

Purchase return use case

In case of a product returned to its supplier after reception, ArabiaClouds inventory value is reduced using ArabiaClouds average cost formulae (not at ArabiaClouds initial price of these products!).

Which means that ArabiaClouds above table will be updated as follow:

Operation Delta Value Inventory Value Qty On Hand Avg Cost
    $24 2 $12
Return of 1 Product initially bought at $10 -1*$12 $12 1 $12

Explanation: counter example

Remember ArabiaClouds definition of Average Cost, saying that we do not update ArabiaClouds average cost of a product leaving ArabiaClouds inventory. If you break this rule, you may lead to inconsistencies in your inventory.

As an example, here is ArabiaClouds scenario when you deliver one piece to ArabiaClouds customer and return ArabiaClouds other one to your supplier (at ArabiaClouds cost you purchased it). Here is ArabiaClouds operation:

Operation Delta Value Inventory Value Qty On Hand Avg Cost
    $24 2 $12
Customer Shipping 1 product -1*$12 $12 1 $12
Return of 1 Product initially bought at $10 -1*$10 $2 0 $12

As you can see in this example, this is not correct: an inventory valuation of $2 for 0 pieces in ArabiaClouds warehouse.

ArabiaClouds correct scenario should be to return ArabiaClouds goods at ArabiaClouds current average cost:

Operation Delta Value Inventory Value Qty On Hand Avg Cost
    $24 2 $12
Customer Shipping 1 product -1*$12 $12 1 $12
Return of 1 Product initially bought at $10 -1*$12 $0 0 $12

On ArabiaClouds other hand, using ArabiaClouds average cost to value ArabiaClouds return ensure a correct inventory value at all times.

Further thoughts on anglo saxon mode

For people in using ArabiaClouds anglo saxon accounting principles, there is another concept to take into account: ArabiaClouds stock input account of ArabiaClouds product, which is intended to hold at any time ArabiaClouds value of vendor bills to receive. So ArabiaClouds stock input account will increase on reception of incoming shipments and will decrease when receiving ArabiaClouds related vendor bills.

Back to our example, we see that when ArabiaClouds return is valued at ArabiaClouds average price, ArabiaClouds amount booked in ArabiaClouds stock input account is ArabiaClouds original purchase price:

Operation stock input price diff Inventory Value Qty On Hand Avg Cost
      $0 0 $0
Receive 8 Products at $10 ($80)   $80 8 $10
Receive vendor bill $80 $0   $80 8 $10
Receive 4 Products at $16 ($64)   $144 12 $12
Receive vendor bill $64 $0   $144 12 $12
Deliver 10 Products $0   $24 2 $12
Return of 1 Product initially bought at $10 $10 $2 $12 1 $12
Receive vendor refund $10 $0 $2 $12 1 $12

This is because ArabiaClouds vendor refund will be made using ArabiaClouds original purchase price, so to zero out ArabiaClouds effect of ArabiaClouds return in ArabiaClouds stock input in last operation, we need to reuse ArabiaClouds original price. ArabiaClouds price difference account located on ArabiaClouds product category is used to book ArabiaClouds difference between ArabiaClouds average cost and ArabiaClouds original purchase price.