Average Cost Method: Definition and Formula with Example

What Is Average Cost Method?

The Average Cost Method is an inventory valuation technique used in accounting and finance to calculate the cost of goods sold (COGS) and the value of ending inventory. Under this method, the average cost of all units in inventory is calculated and applied to both the units sold and the remaining units in stock. The formula for average cost is the total cost of goods available for sale divided by the total units available for sale.

It’s important to note that the Average Cost Method can be applied in both periodic and perpetual inventory systems, offering flexibility for different accounting practices.

How the Average Cost Method works

1. Total Cost of Goods Available for Sale:
   • Add up the total cost of all units available for sale during a specific period, including the beginning inventory and any additional purchases.
2. Total Units Available for Sale:
   • Sum the total number of units available for sale, combining the initial inventory and any units acquired through purchases.
3. Average Cost Calculation:
   • Divide the total cost of goods available for sale by the total units available for sale to determine the average cost per unit.
4. Cost Allocation:
   • Apply the average cost to both the units sold (COGS) and the remaining units in ending inventory.

The Average Cost Method provides a straightforward way to allocate costs, and it tends to smooth out fluctuations in the cost of individual units. This method is commonly used in various industries and suits businesses where specific units are indistinguishable or interchangeable.

Example of Average Cost Method

Let’s illustrate the Average Cost Method with a simple example:

Scenario:

A small electronics store starts the month with 50 laptops in inventory, purchased at $800 each. Midway through the month, the store acquires an additional 30 laptops at $900 each. At the end of the month, the store sells 40 laptops.

Calculation:

1. Total Cost of Goods Available for Sale:
   • \((50 \text{ laptops} \times \$800/\text{laptop}) + (30 \text{ laptops} \times \$900/\text{laptop}) = \$40,000 + \$27,000 = \$67,000\)
2. Total Units Available for Sale:
   • \(50 \text{ laptops} + 30 \text{ laptops} = 80 \text{ laptops}\)
3. Average Cost per Laptop:
   • \(\frac{\$67,000}{80}\) =\( \$837.50\)(rounded to two decimal places)
4. Cost of Goods Sold (COGS):
   • \(40 \times \$837.50 = \$33,50040×$837.50=$33,500\)
5. Ending Inventory:
   • \(40 \times \$837.50 = \$33,50040×$837.50=$33,500\)

Benefits of Average Cost Method

The Average Cost Method offers several benefits in the context of inventory valuation and accounting. Here are some key advantages:

1. Simplicity and Ease of Use
   • The Average Cost Method is straightforward and easy to apply. It simplifies the inventory valuation process, making it accessible for businesses with varying levels of complexity in their inventory systems.
2. Smooths Out Cost Fluctuations
   • By taking the average cost of all units, this method helps smooth out fluctuations in the costs of individual units. This can be particularly advantageous when dealing with interchangeable or indistinguishable items.
3. Reduces Volatility in Financial Statements
   • The method can contribute to reduced volatility in financial statements compared to specific identification methods. This is especially beneficial for businesses that experience significant fluctuations in the costs of their inventory.
4. Applicability to Perpetual and Periodic Systems
   • The Average Cost Method is versatile and can be applied in both perpetual and periodic inventory systems, providing flexibility for businesses with different accounting practices.
5. Accurate Reflection of Average Economic Cost
   • The method aligns with the concept of averaging, providing a reasonably accurate reflection of the average economic cost of inventory items. This can be particularly useful when individual units are interchangeable or when it’s challenging to track specific costs.

Conclusion

In conclusion, the Average Cost Method provides a practical and versatile approach to inventory valuation. Its simplicity and ability to smooth out cost variations make it a valuable tool for businesses seeking a balanced and straightforward method for tracking and valuing their inventory.

FAQs

1. What is the Average Cost Method?

• Answer: The Average Cost Method is an inventory valuation technique that calculates the average cost per unit by dividing the total cost of goods available for sale by the total units available for sale.

2. How is the Average Cost per Unit Calculated?

• Answer: The formula for calculating the average cost per unit is:  \text{Average Cost} = \( \frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Units Available for Sale}}\)​

3. In What Situations is the Average Cost Method Beneficial?

• Answer: The Average Cost Method is beneficial in industries where individual units are indistinguishable or interchangeable. It is also suitable for businesses seeking a straightforward approach to inventory valuation.

4. Can the Average Cost Method Be Used in Both Periodic and Perpetual Inventory Systems?

• Answer: Yes, the Average Cost Method is versatile and can be applied in both periodic and perpetual inventory systems.

5. How Does the Average Cost Method Impact Financial Statements?

• Answer: The Average Cost Method impacts financial statements by influencing the calculation of the cost of goods sold (COGS) and the valuation of ending inventory.

6. Does the Average Cost Method Require Complex Record-keeping?

• Answer: No, the Average Cost Method is known for its simplicity and ease of use, reducing the complexity of record-keeping compared to methods that involve tracking specific costs for each unit.

7. Can the Average Cost Method be Used Alongside Other Valuation Methods?

• Answer: In many cases, businesses can choose to switch between inventory valuation methods. However, it’s important to maintain consistency for accurate financial reporting.