Average Cost
In accounting, the average cost refers to the method used to assign a value to inventory items based on the average cost of all items available for sale during a specific period. It is a way to determine the cost of goods sold (COGS) and the ending inventory value. The average cost method is also known as the weighted-average cost method.
To calculate the average cost, you divide the total cost of goods available for sale by the total number of items available for sale. The formula for average cost is:
\(\text{Average Cost} = \frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Number of Items Available for Sale}} \)
This method is particularly useful when dealing with inventory items that are indistinguishable from one another and have relatively stable costs. It smoothes out the cost fluctuations and provides a more stable cost figure for inventory valuation and cost of goods sold.
Example of Average Cost
Let’s assume a company sells widgets and has the following inventory transactions during a month:
- Beginning inventory: 100 widgets at $10 each (Total cost: $1,000)
- Purchase on 15th of the month: 50 widgets at $12 each (Total cost: $600)
- Purchase on 25th of the month: 70 widgets at $14 each (Total cost: $980)
At the end of the month, the company has sold 180 widgets. To calculate the average cost, we first determine the total cost of goods available for sale and the total number of items available for sale.
Total Cost of Goods Available for Sale = $1,000 (Beginning inventory) + $600 (First purchase) + $980 (Second purchase) = $2,580
Total Number of Items Available for Sale = 100 (Beginning inventory) + 50 (First purchase) + 70 (Second purchase) = 220
\(\text{Average Cost} = \frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Number of Items Available for Sale}} = \frac{2,580}{220} \)
= $11.73 per widget (rounded to two decimal places)
Now we can calculate the cost of goods sold (COGS) and the ending inventory value:
COGS = 180 widgets sold * $11.73 (Average cost) = $2,111.40
Ending Inventory Value = 40 widgets remaining (220 – 180) * $11.73 (Average cost) = $468.60
So, using the average cost method, the cost of goods sold for the month is $2,111.40, and the ending inventory value is $468.60.
