What is the Average Cost Method?
Definition: Average cost method, also called weighted average, is a way of assigning costs to inventory when it is sold. Some companies choose to use the average method instead of other valuation methods like FIFO or LIFO because the weighted average method minimizes the drastic effects of assigning costs based on the purchase date.
What Does Average Cost Method Mean?
For instance, FIFO assigns costs to the sold inventory based on the first purchase date. The first product purchased will be the first item sold. As inventory ages and prices continue to rise, the FIFO method tends to overstate inventory levels because only higher priced inventory purchased at later dates remains on the balance sheet. The first purchased inventory that was purchased at a lower cost is sold off first.
Conversely, LIFO has the opposite effect on the balance sheet by selling the last items purchased first. This method results in an understated inventory level and a lower net income for the period.
You can look at the average cost method as a middle ground between these two inventory valuation methods. It calculates the average cost of all inventory on hand and uses that as the cost when an item is sold. The average cost method formula is calculated by dividing the cost of goods available for sale by the total units available. This is the cost assigned to each piece of inventory sold.
Under the ‘Average Cost Method’, it is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period.
The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale. This gives a weighted-average unit cost that is applied to the units in the ending inventory.
There are two commonly used average cost methods:
- simple weighted-average cost method;
- perpetual weighted-average cost method.
Let’s assume that Ashley’s Furniture store has 10 pieces of inventory. She bought the first 3 for $1,000 each, the second 3 for $1,500 each, and the last 4 for $2,000 each. Her total cost of available inventory for sale is $15,500, so here average cost per item is $1,550.
Ashley would record a cost of $1,550 when she sells each piece of furniture by debiting cost of goods sold and crediting inventory.
Weighted Average Cost
Weighted Average Cost is a method of calculating Ending Inventory cost. It is also known as WAVCOs
It takes Cost of Goods Available for Sale and divides it by the number of units available for sale (number of goods from Beginning Inventory + Purchases/production). This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the number of goods left. Finally, this quantity is multiplied by Weighted Average Cost per Unit to give an estimate of ending inventory cost. The cost of goods sold valuation is the amount of goods sold times the Weighted Average Cost per Unit. The sum of these two amounts (less a rounding error) equals the total actual cost of all purchases and beginning inventory.
Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost.
Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, purchase costs are added to beginning inventory cost to get Cost of Current Inventory. Similarly, the number of units bought is added to beginning inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods.
Also during the year, multiple sales happen. The Current Goods Available for Sale is deducted by the amount of goods sold, and the Cost of Current Inventory is deducted by the amount of goods sold times the latest (before this sale) Current Cost per Unit on Goods. This deducted amount is added to Cost of Goods Sold.
At the end of the year, the last Cost per Unit on Goods, along with a physical count, is used to determine ending inventory cost.
Average Costing Advantages
Average costing works well in the following situations:
- When it is difficult to track the cost associated with individual units. For example, it can be applied where individual units are indistinguishable from each other.
- When raw material costs move around an average cost point in an unpredictable manner, so that an average cost is useful for long-term planning purposes (such as in the development of a budget).
- When there are large volumes of similar items moving through inventory, which would otherwise require considerable staff time to track on an individual basis.
- Also, this method requires little labor, and so is among the least expensive of the cost accounting methodologies to maintain (the other major cost accounting methods are the FIFO and LIFO methods).
Average Costing Disadvantages
Average costing does not work well in the following situations:
- When the units in a batch are not identical, and therefore cannot be treated in an identical manner for costing purposes.
- When inventory items are unique and/or expensive; in these situations, it is more accurate to track costs on a per-unit basis.
- When there is a clear upward or downward trend in product costs, average costing does not provide a clear indication of the most recent cost in the cost of goods sold. Instead, being an average, it presents a cost that may more closely relate to a period some time in the past.