What is the average-cost method?

Any business that sells products must find an efficient way to deal with inventory. Inventory includes any goods to be sold, whether purchased from a manufacturer or produced by the business. Learn more about the potential benefits of the average-cost method.

Average cost method definition

Also referred to as the weighted average cost method, the average-cost method is an accounting formula used when calculating inventory value. This figure is reached by dividing the total cost of goods by the total number of goods over a specific accounting cycle. The average-cost method is simple to use, whether the goods are produced or purchased by the business.

Inventory valuation methods

To calculate the cost of inventory items, there are three valuation methods available to businesses. These include:

• First in, first out (FIFO)

• Last in, first out (LIFO)

• Average-cost

All three are equally valid, but one thing to keep in mind is that once a business chooses the method, it will need to remain consistent across all financial reports.

How does the weighted average cost method work?

The average-cost method is useful to businesses for several reasons. It assigns value to the cost of goods sold (COGS) by using the weighted average of all the inventory that the company purchased during a period of time. The period could be a month, quarter, or annual period, so long as it remains consistent. In addition to assigning value to the cost of goods sold, it also assigns value to the cost of goods that are still available as inventory.

To keep accurate financial records, businesses are required to include the cost of goods sold (COGS) on an income statement. The COGS figure is then subtracted from sales revenue to determine the company’s gross margin. This figure is essential for the business itself, as well as any investors or financial analysts, so it must be recorded accurately. The average-cost method is one of the most straightforward ways to determine COGS over a specific period.

Average cost method example

Imagine a company that sells electronics items. Here is the sales ledger during their first quarter accounting period.

During this accounting period, the electronics company purchased 80 items for a total cost of $47,000.

By dividing the total cost ($47,000) by the total number of items purchased (80), you arrive at the weighted-average cost per item of $587.50.

Now imagine that this same company sold 50 units during this same accounting period. The cost of goods sold (COGS) would be recorded as 50 units sold x $587.50 average cost, or $29,375.

To calculate the cost of goods still for sale, you would multiply the 30 remaining items by $587.50 average cost, which equals $17,625.

Average cost method advantages and disadvantages

The main benefit of the average-cost method is its simplicity, particularly for companies that deal with large volumes of very similar items. Rather than tracking each item and its individual cost, these figures can be averaged.

Businesses that deal with raw materials will often use the average cost method because these materials can fluctuate in price over time. Averaging the costs helps with long-term planning and budget-making.

However, the weighted average cost method won’t work equally well in every situation. For example, when the batch units are very different, it may not make sense to treat them identically from a cost perspective. This is particularly true when the inventory items are rare, expensive, or unique, such as antique furnishings or custom jewelry.

Average costing doesn’t work as well when production costs are trending upward or downward over time. This would diminish the accuracy of financial records, reflecting the cost during the specific period, rather than a consistent average.

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