Average Cost Method

Understanding the average cost method

The average cost method calculates the cost of inventory by dividing the total cost of goods produced/acquired during a period by the total number of items produced or purchased. This method is also known as the weighted average method.

How the average cost method works?

Businesses that sell products need to manage inventory, whether it's bought from another manufacturer or produced in-house. The cost of goods sold (COGS) on an organisation's income statement includes the cost of items that were in inventory and have been sold. COGS is subtracted from sales revenue to determine the gross margin, which is essential for businesses, investors, and analysts.

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Pros and cons of the average cost method

Advantages:

  • Simplicity: This is ideal for businesses with large volumes of similar items. Instead of tracking individual costs, averages can be used.
  • Stability: This is useful for companies dealing with raw materials whose costs may fluctuate. Averaging costs helps with budgeting and long-term planning.

Disadvantages:

  • Not Always Accurate: Less effective for inventories of unique, expensive, or specialised items, like antiques or handcrafted goods.
  • Variable Costs: The average cost method can reduce financial accuracy when production costs vary significantly over time.

How to calculate the average cost?

If you want to calculate the weighted average cost per unit, use the AVCO formula:

(Sum) cost of goods produced / (Sum) number of items sold = Average cost for the period

Imagine a company, XYZ Electronics, manufactures and sells smartphones. During a particular month, XYZ Electronics produced and sold the following batches of smartphones:

  • Batch 1: 100 units at a total cost of $20,000
  • Batch 2: 150 units at a total cost of $30,000
  • Batch 3: 200 units at a total cost of $40,000

To calculate the weighted average cost per unit, you would use the AVCO formula:

Average Cost = (Total Cost of Goods Produced) / (Total Number of Items Sold)

Here's the calculation:

  1. Sum of Costs: $20,000 + $30,000 + $40,000 = $90,000
  2. Sum of Units Sold: 100 + 150 + 200 = 450 units

Average Cost per Unit: $90,000 / 450 units = $200 per unit

So, the weighted average cost per unit for XYZ Electronics during that period is $200.

Special considerations

Consistency: According to US generally accepted accounting standards (GAAP), a company must consistently use the chosen accounting method from one period to the next. If a company changes its inventory-costing method, it must disclose the change in the financial statements' footnotes and apply the new method retroactively.

Learn more: Everything you need to know about pro forma statements.

In summary

  • The average cost method is one of three ways to value inventory alongside first in, first out (FIFO), and last in, first out (LIFO).
  • It uses the weighted average of all inventory purchases during a period to value COGS and remaining inventory.
  • Consistency is crucial under GAAP, so once a company chooses a method, it must stick with it for all future periods.

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