Adopting inventory accounting methods and using them consistently is an important part of a company’s financial and inventory management. One of the common methods that businesses use to achieve this goal is the average cost method, also known as the weighted average method.
How a company keeps track of inventory accounting for each accounting period is a fundamental strategy that has a major influence on business profits. In this article, we discuss what the average cost method is, how to use the average cost formula and provide examples of its use.
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What is the average cost method?
The average cost method (AVCO) assigns a weighted average cost to a large number of similar units rather than using the individual unit costs.
AVCO is one of three inventory valuation methods used to calculate the cost of inventory items for an accounting period. Two other common methods are first-in, first-out (FIFO) and last-in, first-out (LIFO).
By assigning weighted average costs to inventory items, calculating the cost of inventory at the end of the accounting period is very simple.
Benefits of using the average cost method
The average cost method is often the easiest to implement and the least expensive to maintain of the three inventory valuation methods. AVCO works very well in certain situations, such as when there are:
- Large volumes of goods of the same price move through inventory
- Identical or barely distinguishable inventory units
- Individual units are too difficult or too time-consuming to track
- Fluctuating material costs or unpredictable production costs
- Long-term planning objectives where knowing the average unit cost is useful
How to calculate the average cost method?
To calculate the weighted average cost per unit of inventory, you use the AVCO formula. This formula takes the total cost of inventory and divides that amount by the total number of units in inventory. The resulting quotient is the weighted average cost per unit.
The formula for the average cost method is:
The total cost of inventory / total units in inventory = weighted average unit cost
Here are the steps to use the AVCO formula:
1. Determine the average cost of all purchased inventory
First, find the total cost of all the individual inventory items purchased. Second, divide that number by the number of items. The result is the average cost per item.
For example: If a company made five inventory purchases during May for 500,000, 300,000, 400,000, 700,000, and 600,000, they would add up the five purchases for a total of 2,500,000. Then the company will take the total number of items they purchased, 575 items, and divide 2,500,000 by 575 items. The result is a weighted average cost of 4,350 per item (2,500,000/575 = 4,350).
2. Determine the average cost of all inventories produced
If a business uses raw materials to produce its own inventory, then it will take the total cost of production and divide that amount by the total number of inventory items produced. The result is the average cost per item.
For example: If a business makes its own T-shirts, then it will add up all the costs of raw materials such as fabric, yarn, tags, dyes and other purchases for the production of T-shirts. If a business spends 5,000,000 on all raw materials and produces 800 T-shirts, then dividing 5,000,000 by 800 T-shirts will yield a weighted average cost of 6,250 per T-shirt (5,000,000/800 = 6,250).
3. Calculate the total cost of inventory sold
First, calculate the total number of inventory items sold. Second, multiply that number by the average cost per item. The result is the average total cost of goods sold.
For example: If a T-shirt company sold 500 of the 800 T-shirts they produced in April, they would multiply the 500 T-shirts sold by a weighted average cost of 6,250 for each T-shirt. The result is 3,125 in inventory sold (500 x 6250 = 3,125,000).
4. Calculate the total cost of ending inventory
First, calculate the total number of unsold items that are still in stock. Second, multiply that number by the average cost per item. The result is the total average cost of ending inventory.
For example: If a T-shirt company sells 500 of the 800 T-shirts they produce, then the 300 unsold T-shirts will remain in stock. They would multiply the 300 unsold T-shirts by the weighted average cost of 6,250 of each T-shirt by a total of 1,875,000 in ending inventory (300 x 6,250 = 1,875,000).
The AVCO formula can also be applied to a periodic inventory system or a perpetual inventory system. With a periodic inventory system, you can find the cost of goods sold and the value of ending inventory by calculating the weighted average per unit and then multiplying that number by the number of units sold or the number of units in ending inventory.
With a perpetual inventory system, you can calculate the weighted average cost per unit before each sales transaction.
Uses and Implications of AVCO
When using the AVCO method, factors such as economy, quality and quantity of goods produced or purchased, among others, must be considered. In a booming economy, product prices will continue to rise, and large purchases are made near the end; the average cost will be very high. If the goods are produced or purchased at the beginning of the calculation, the average cost will be lower.
However, in a deflationary economy, making a large purchase late in the calculation will yield a much lower average than making a large purchase early in the calculation.
As you may have concluded, the periodic inventory system and the perpetual inventory system both produce slightly different results when calculating the average cost of goods. Companies can choose to work with one of the inventory systems when using the AVCO method.
In a periodic inventory system, inventory is carried out at certain intervals. Faster to calculate in bulk. Average cost uses all items available for sale and calculates the average cost of all of them at once. With a perpetual inventory system, each time a transaction occurs, the average cost is recorded. The automated system can figure this out for you, as it is an iterative process.
Periodic inventory
Continuing the example, the lighting company has 300 units for sale and 200 of them were sold during the month of June.
To start, it takes the total number of items sold, 300, then subtracts the total number of items sold, 200, which results in 100 items still in stock (300 – 200 = 100).
Then, calculate the cost for items sold by multiplying the number of items sold, 200, by the weighted average cost, $15.75. This gives the average total cost of goods sold, $3,150 (200 x $15.75 = $3,150).
Then, calculate the cost for the items in ending inventory by multiplying the number of items in ending inventory, 100, by the weighted average cost, $15.75. This gives the average total cost of the items remaining in inventory, $1,575 (100 x $15.75 = $1,575).
Conclusion
That’s a complete discussion of the average cost method of business inventory management systems. The Average Cost Method is an accounting technique used to find the average price of goods recorded in inventory. As with any method that uses an average, AVCO takes the total cost of all items in your inventory and divides it by the total number of items in inventory at the time of calculation.
You find the total cost of goods available for sale by multiplying the price of each product by the number of products available and adding them all up.
When solving accounting problems using the AVCO method, check the perpetual or periodic inventory system. If the value of goods sold and the inventory balance must be calculated each time a new purchase is made, then you are dealing with a perpetual inventory system. If the value of goods sold and the inventory balance must be calculated after a certain period of time, then use the AVCO method for periodic inventory.