What Is Average Cost Method?
You need to know that the average cost method assigns a cost to your inventory items based on the total cost of goods you purchased or produced in a period, divided by the total number of items you purchased or produced. I refer to it as the weighted-average method sometimes.
How It Works
Understand that this method is one of three main inventory valuation approaches, alongside first in, first out (FIFO) and last in, first out (LIFO). It uses the weighted average of all inventory you purchased in a period to assign value to your cost of goods sold (COGS) and the cost of goods still available for sale. Once you select this method, stick with it consistently to comply with generally accepted accounting principles (GAAP).
Example
Consider this inventory ledger for a company like Sam’s Electronics: purchases on 1/1 of 20 units at $1,000 each totaling $20,000; on 1/18 of 15 units at $1,020 each totaling $15,300; on 2/10 of 30 units at $1,050 each totaling $31,500; on 2/20 of 10 units at $1,200 each totaling $12,000; and on 3/5 of 25 units at $1,380 each totaling $34,500, for a total of 100 units costing $113,300. If you sold 72 units in the first quarter, the weighted average cost is $113,300 divided by 100, or $1,133 per unit. Your COGS would then be 72 units times $1,133, equaling $81,576, and the ending inventory of 28 units would be $31,724.
Benefits
This method requires minimal labor to apply, making it the least expensive option among inventory methods. It also prevents easy manipulation of income, unlike some other approaches. You should use it if your products are indistinguishable or if tracking individual unit costs is difficult, especially with large volumes of similar items moving through inventory.
Special Considerations
Remember that GAAP emphasizes consistency, so if you adopt the average cost method, continue using it across accounting periods. This allows users of your financial statements to compare figures year over year. If you change methods, disclose it in your financial statement footnotes and apply it retroactively to prior periods.
FAQs
The average cost method formula is total cost of goods purchased or produced in the period divided by the total number of items purchased or produced, giving you the average cost for the period, which you can apply to COGS and ending inventory. Use it for simplicity, especially with large volumes of similar items, as it applies a weighted average across all at period-end. Under GAAP, acceptable methods include LIFO, FIFO, or average cost, but IFRS does not allow LIFO since it may not reflect actual inventory flow.
The Bottom Line
In summary, the average cost method is one of three inventory valuation methods that assigns costs based on the total cost of goods purchased or produced divided by the number of items, providing a straightforward way to handle inventory valuation.
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