fbpx

What is the Average Cost Method?

Average Cost Method

Share This...

Average Cost Method

The average cost method is an inventory costing method used in accounting to calculate the value of inventory and the cost of goods sold (COGS). Under the average cost method, the cost of goods available for sale is divided by the total number of items available for sale to determine the average cost per item. This average cost is then used to assign costs to both the inventory sold and the inventory remaining at the end of the period.

The average cost method can be applied to both periodic and perpetual inventory systems. In a periodic inventory system, the average cost is calculated at the end of the accounting period, while in a perpetual inventory system, the average cost is updated continuously whenever there’s a new purchase.

The main advantage of the average cost method is that it smooths out the impact of fluctuations in the purchase cost, which can occur due to discounts, bulk purchases, or changes in supplier prices. This method is especially useful when it’s difficult to track individual inventory items or when the cost of items doesn’t vary significantly. However, the average cost method may not accurately reflect the actual flow of costs when there are significant cost fluctuations or when specific identification of inventory items is possible and more appropriate.

Example of the Average Cost Method

lLet’s say a company sells a single type of product and has the following inventory transactions during a month:

  • Beginning inventory: 100 units at $10 per unit
  • Purchase on 10th: 50 units at $12 per unit
  • Purchase on 20th: 100 units at $11 per unit
  • Sales during the month: 180 units

To calculate the average cost per unit, we first determine the total cost of goods available for sale and the total number of units available for sale:

Total cost = (100 units x $10) + (50 units x $12) + (100 units x $11)
= $1,000 + $600 + $1,100
= $2,700

Total units = 100 units + 50 units + 100 units
= 250 units

Now, we find the average cost per unit:

Average cost per unit = Total cost / Total units = $2,700 / 250 units
\(\text{Average cost per unit} = \frac{\text{Total cost}}{\text{Total units}} = \frac{2,700}{250 \text{ units}} \)
= $10.80

With this average cost per unit, we can calculate the cost of goods sold (COGS) and the ending inventory value:

COGS = 180 units sold x $10.80
= $1,944

Ending inventory value = 70 remaining units x $10.80
= $756

Using the average cost method, the cost of goods sold for the month is $1,944, and the value of the ending inventory is $756.

Other Posts You'll Like...

Want to Pass as Fast as Possible?

(and avoid failing sections?)

Watch one of our free "Study Hacks" trainings for a free walkthrough of the SuperfastCPA study methods that have helped so many candidates pass their sections faster and avoid failing scores...