Average Cost Method: What Is It?
The average cost approach divides the entire cost of products produced or acquired in a given time by the total number of things produced or purchased and then applies that cost to inventory items. The weighted average approach is another name for the average cost method.
Comprehending the Average Cost Approach
Companies that offer goods to consumers must deal with inventory, which they either make internally or purchase from another manufacturer. Sold items from inventory are reported as cost of goods sold (COGS) on an organization’s income statement. For companies, investors, and analysts, COGS is crucial since it is deducted from sales revenue to calculate the gross margin on the income statement. Various businesses employ one of three inventory cost methodologies to determine the overall cost of items supplied to customers during a specific period:
- Initial in, initial out (FIFO) and
- Last in, initial out (LIFO)
- The average-cost approach
The average cost technique counts the remaining inventory items after an accounting period after taking a simple average of all comparable goods in inventory, regardless of the date of purchase. The corporation calculates the cost of products available for sale at that moment by multiplying the average cost per item by the final inventory count. To calculate the COGS, multiply the total number of products sold during the previous accounting period by the precise average cost.
Example of Average Cost Method
For example, consider the following inventory ledger for Sam’s Electronics:
| Purchase date | Number of items | Cost per unit | Total cost |
| 1/1 | 20 | $1,000 | $20,000 |
| 1/18 | 15 | $1,020 | $15,300 |
| 2/10 | 30 | $1,050 | $31,500 |
| 2/20 | 10 | $1,200 | $12,000 |
| 3/5 | 25 | $1,380 | $34,500 |
| Total | 100 | $113,300 |
Let’s say that during the first quarter, the firm sold 72 units. The weighted average cost comes out to an average of $1,133 per unit, calculated by dividing the entire amount of inventory acquired during the quarter ($113,300) by the total number of inventory counts ($100). The amount that will be reported as the cost of goods sold (COGS) is 72 units sold x $1,133 average cost, or $81,576. After that, the cost of products available for sale, or inventory, will equal the remaining 28 items in inventory × $1,133, or $31,724.
Advantages of the Average Cost Approach
The average cost approach is the least expensive of all the techniques since it needs the least labor to implement. Apart from its ease of application, the average cost approach is less manipulable than other inventory-costing techniques in terms of income. Businesses that sell identical items or have trouble determining the cost of individual units will typically opt to employ the average cost approach. This is especially beneficial when a high volume of comparable items is going through inventory, and tracking each item individually takes time.
Particular Points to Remember
Consistency is a fundamental component of generally accepted accounting standards (GAAP) in the United States. To comply with the consistency principle, a business must choose an accounting technique and stick to it consistently from one accounting period to the next.
For instance, businesses that utilize the average cost technique must stick with it for all upcoming accounting periods. This principle has been put in place to make financial statement comparisons between years easier for consumers. When a corporation modifies its inventory-costing methodology, it must retroactively apply it to comparable financial statements from previous periods and acknowledge the modification in its footnotes.
What is the formula for the average cost method?
The formula for calculating the average cost is as follows:
The average cost for the period is equal to the total cost of goods purchased or produced ÷ the total number of items purchased or produced in the period. The outcome may impact the cost of goods kept in inventory at the end of the period and the cost of goods sold (COGS).
Why should I apply the approach of average cost?
An easy way to value inventory is to use the average cost technique, which works well for companies with identical inventories. After the conclusion, the weighted average can be applied to all related things rather than recording each item.
According to generally accepted accounting principles (GAAP), which methods are acceptable for calculating inventory costs?
The average cost technique, first in, first out (FIFO), and last in, first out (LIFO) are all permitted inventory valuation methods under GAAP. However, IFRS (International Financial Reporting Standards) prohibits LIFO as it generally misrepresents the actual inventory movement inside a company.
Conclusion
- One of the three commonly used techniques for inventory valuation is the average cost approach; the other two are first in, first out (FIFO) and last in, first out (LIFO).
- The average cost technique values the cost of goods sold (COGS) and the cost of items still available for sale by taking the weighted average of all inventory acquired during a given period.
- Once an inventory valuation technique is chosen, a business must stick to it to follow generally accepted accounting principles (GAAP).
