DEFINITION of Average Cost Flow Assumption
Average cost flow assumption is a calculation companies use to assign costs to inventory goods, cost of goods sold and ending inventory. The method utilized to assign costs to inventory and cost of goods sold can affect a company's profitability. Companies use one or more methods to make certain assumptions regarding which goods have been sold and which remain in inventory. Under the average cost flow assumption, an average is taken of all of the goods sold from inventory, over the accounting period and that average cost is assigned to the goods.
Average cost flow assumption is also called "weighted average cost flow assumption."
BREAKING DOWN Average Cost Flow Assumption
The average cost flow assumption takes an average of the cost of items sold and leads to a mid-range cost of goods sold figure. The average cost flow assumption assumes that all goods of a certain type are interchangeable and only differ in purchase price. The purchase price differentials are attributed to external factors including inflation, supply, or demand. Under average cost flow assumption, all of the costs are added together, then divided by the total number of units that were purchased. The number of units sold can be multiplied by the average price per unit to establish the cost of goods sold and the ending inventory.
Example of Average Cost Flow Assumption Method
For example, let's assume that Wexel's Widgets Inc. utilizes the average cost flow assumption when assigning costs to inventory items. During the accounting period, Wexel sells 25 widgets from bucket A, each of which cost $25 to produce; 27 widgets from bucket B, each of which cost $27 to produce; and 30 widgets from bucket C, each of which cost $30 to produce. The widgets are all interchangeable, only differing in the cost of production, due to an increase in the cost of the plastic explosive used in the manufacturing process. To compute the total cost of goods sold (COGS), Wexel utilizes the average cost flow assumption method. He computes the cost of each widget as follows: [(25x$25) + (27x$27) + (30x$30)] / (25+27+30).