What is the 'Average Cost Method'

The average cost method is an inventory costing method in which the cost of each item in an inventory is calculated on the basis of the average cost of all similar goods in the inventory. The average cost method is calculated by dividing the cost of goods in inventory by the total number of items available for sale.

The average cost method is also known as the weighted average.

BREAKING DOWN 'Average Cost Method'

Businesses that offer goods and products to customers have to deal with inventory, which is either bought from a manufacturer or produced by the business itself. Items in an inventory that are sold off have to be recorded on a company’s income statement as Cost of Goods Sold (COGS). The COGS is an important fundamental for businesses, investors, and analysts as it is subtracted from Revenues to determine gross margin, the first profit line on the income statement. To calculate the total cost of goods sold to consumers during a period, different companies use one of three inventory cost methods – First In First Out (FIFO), Last in First Out (LIFO), and Average Cost method.

Average Cost Method Example

The average cost method takes the average price of all the goods in stock, regardless of purchase date, and this value represents the cost of goods sold in the income statement. For example, consider the following inventory ledger for Sam’s Electronics:

Purchase date

Number of items

Cost per unit

Total cost

01/01

20

$1,000

$20,000

01/18

15

$1,020

$15,300

02/10

30

$1,050

$31,500

02/20

10

$1,200

$12,000

03/05

25

$1,380

$34,500

Total

100

 

$113,300

If the company sold 72 units in the first quarter, the weighted average cost will be $113,300/100 = $1,133/unit. The cost of goods sold will, therefore, be recorded as 72 x $1,133 = $81,576. The ending inventory at the end of the period will be 28 x $1,133 = $31,724.

The average cost method requires little labor to apply, and is therefore, the least expensive of all the methods. In addition to the simplicity of applying the average cost method, income cannot be as easily manipulated as with the other inventory costing methods. Companies that sell products that are indistinguishable from each other or that find it difficult to find the cost associated with individual units prefer to use the average cost method. This also helps when there are large volumes of similar items moving through inventory, making it time consuming to track each individual item.

To abide by the consistency principle, which requires businesses to adopt an accounting method and follow it consistently from one accounting period to another, businesses that adopt the average cost method have to stick to this method for future accounting periods. A company that changes its inventory costing method must reflect the change in its financials for investors.

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