Academics Business & Management

Average Cost Method: A detailed explanation

Average Cost

Average Cost Method: The industrial revolution has instigated the need for developing cost accounting because of the rapid growth and development of businesses. Prior to industrialization, most of the business organisations were small and medium in size. Therefore, those organisations operate their regular business by using conventional accounting system to accounting purpose. That time, they did not realize the need for a separate accounting system that could assist them to measure and analyse costs in a separate manner. After that, the era of industrial revolution turned the face of business organisations in respect of operations, scale, and structure. Business organisations have grown and developed vastly and due to this, the complexities of business operations also increased. Most importantly, in large business organisations the need for tracking costs become crucial for the successful and hassle-free business operations. Thus, the increasing complexities in business operations and dynamic business environment instigated the need for effective management and this accordingly becomes the reason behind the emergence of the cost accounting system.

The need of improving management system and business activities of large and medium size companies has provoked the evolution of cost accounting system. Cost accounting is a branch of accounting that solely involves in collecting, analysing, recording, summarising, interpreting, and reporting financial data and information of a business organisation. Over the passing time, cost accounting system developed and a number of arms are added to it. One of its arms is average cost method. Average cost method refers to a method of inventory costing and by applying this method cost of every single item in a company’s inventory is computed on the basis of the average cost of all the similar items present in the total inventory. This method is calculated by dividing the total cost of items (goods) in inventory by the total unit of goods, present in the total inventory, available to the company for conducting sales activities.

This method is also known as weighted average method. Under this method, the cost of inventory is assumed on the basis of the average cost of goods available in a company’s hand for sale during a particular period. Now our experts from Assignment Help Canada will tell you the definition and objective of Average Cost Method

Definition and Objectives of Average Cost Method

The average cost method is a method of calculating the cost of inventory. In order to calculate the average cost of inventory, the total cost of inventory and number of items or units present in the total inventory is considered. The average cost method is a process of assigning relevant costs to each item in inventory at the time of selling such inventory item. Some business organisations choose to apply average method rather than using other inventory valuation methods such as LIFO (last-in-fast-out) or FIFO (first-in-first-out) because average cost method uses to minimize the drastic and sometimes negative effects of allocating costs on the inventory items on the basis of such item’s value on the date of purchase.

The objective of using the average cost method for inventory valuation is to calculate the cost of ending inventory by using weighted-average cost per unit. It is applied for determining per unit cost of similar kinds of inventory items like identical electrical equipment in a hardware shop or toy in a toy store. Since the inventory items are alike, companies become able to assign the same cost per unit. The two major objectives of average cost method include assisting a company to calculate its inventory in a simple and easy manner and helping the company to compute income from business accurately. This method also aimed to help a company to avoid manipulation in income calculation and unnecessary complexities while calculating its inventory. Another objective of average cost method is ensuring the company about the accuracy of inventory cost and cost of goods sold both of which are highly significant for measuring a company’s actual income for a specific financial period.


Description and formula of Average Cost Method

A company that offers products and services to customers needs to deal with inventories. A company offers products to the final customers by either purchasing the same from one of two manufacturers of the products or produced by it. The items of inventory a company uses to sell out must be recorded on the income statement of the company as COGS (Cost of Goods Sold). Cost of Goods Sold is a fundamental element for companies, investors, and trade analysts because it is deducted from the total revenue earned by a company during a specific financial period for determining gross margin. Gross margin stands at first in the line of profit of a company in its income statement. For calculating the total COGS to consumers for a particular period, different types of companies use different types of methods to calculate the cost of their inventory.

There are three types of inventory costing methods such as First-In-First-Out (FIFO), Last-In-First-Out (LIFO), and Average Cost method. The average cost method or the weighted-average inventory costing is a method of costing where the cost of ending inventory is calculated by using weighted-average cost per unit of inventory. The average cost method is much more acceptable in today’s complex business environment for calculating the cost of inventory. For example, First-in-first-out (FIFO) method uses to assign costs to a company’s inventory that is sold on the basis of the date of first purchase of such inventory. Under the FIFO method, the product purchased first is sold by the purchasing company first in comparison to the other products. As ages of the inventory and its price continue to increase, this method overstates the levels of a company’s inventory because only the high priced inventory that is purchased at an after date presents in the company’s annual balance sheet. This is because the first purchased item of inventory, purchased at a lower price, is sold out first.

On the other hand, Last-in-fast-out (LIFO) method is opposite to FIFO and creates an opposite effect on a company’s balance sheet. Under this method, last purchased inventory items are sold out first than others. This particular method understates the level of inventory and constitutes net income at a lower value for the financial period. Average cost method stands as a middle ground between LIFO and FIFO, the two conventional methods of inventory valuation. This method uses to calculate the average cost of total inventory in hand and utilises that cost as the selling price of such inventory. The formula of average cost method is as follows –

Average Cost Method = Total cost of goods in inventory (available for sale) / Total units available

The application of average cost method needs little labour, and therefore, it is considered as the least costly method of inventory valuation in comparison to other methods. In addition, it is the simplest method of inventory valuation and trustworthy because the income of a company cannot be manipulated if the company uses the average cost method for valuing its inventory. In case of using other inventory costing methods, there are some grounds to manipulate income figure easily by calculating inventory cost in a manipulated way. A company that sells indistinguishable products or the products that are difficult to differentiate from each other often found it tough to compute the cost attached to per unit of such product and to overcome this problem that company prefers to apply average cost method.

Furthermore, this method helps a company to track every single product when it operates by moving huge volumes of almost identical products through inventory. In order to abide by the principle of consistency according to which a company requires to adopt a specific accounting method as well as follow the same in a consistent manner during the accounting periods, companies that adopt this particular inventory costing method must stick to it for the upcoming accounting periods. On the other side, a company is free to change its inventory costing method from average cost method to any other cost method but in such case, that company needs to reflect such change through its financial statements for its investors and other stakeholders. Now our experts from Assignment Help will tell you how to calculate Average Cost Method.

Way to Calculate Average Cost Method

As the name says, average cost method uses to price items lying in a company’s inventory by considering the average cost of every similar product or item as available in the company’s hand for sale during a particular period. The process of calculating the weighted average cost of inventory, an example is provided below.

In the below stated example showing the average cost method of valuing inventory, it is assumed that the company has conducted the following transactions in its first month of business operations.

Date Purchases (Units) Rate (per unit) Sold/Issued (Units) Balance (Units)
01-05-2019 2,000 @ $4.00   2,000
15-05-2019 6,000 @ $4.40   8,000
19-05-2019     4,000 4,000
30-05-2019 2,000 @ $4.75   6,000

Here, it is assumed that the above data is derived from a fictitious company that has used periodic inventory method, COGS (cost of goods sold) and ending cost of inventory of the company is computed by using weighted average cost method.

Invoice Date No. of Units Cost per Unit Total Cost
01-05-2019 2,000 $4.00 $8,000
15-05-2019 6,000 $4.40 $26,400
30-05-2019 2,000 $4.75 $9,500
       
Total Inventory 10,000   $43,900
       
Weighted Average Cost of inventory (per unit) = $43,900/10,000 = $4.39
Inventory in units (Closing Inventory) = (10,000 – 4,000) * $4.39 = $26,340
  Cost of goods available for sale $43,900  
  Less: Closing inventory 26,340  
  Cost of goods sold $17,560  
       

In the above case, the company has no opening inventory but it has opening inventory, then it is added in the total available units for sale as well as in the total cost of goods available for sale while calculating per unit average cost of inventory.

Advantages of Average Cost Method

The average cost method is one of the most commonly applied methods used in assigning costs to each of the items in inventory and in determining the value attached to the cost of goods sold. This method is used in both perpetual inventory and periodic inventory system. There are a number of advantages of applying the average cost method for calculating inventory and these advantages make this method one of the popular methods of inventory valuation among the other methods. The advantages of average cost method are stated below.

Simplicity

The biggest benefit of using the average cost method instead of other methods like LIFO and FIFO is its simplicity that helps the users to calculate inventory value in a very simple and easy manner. This method also simplifies the process of record keeping as well as simplifies the processing of inventory ordering even if the company operates with a high frequency of inventory ordering. Bookkeepers do not keep the track of every single batch of inventory bought in along with its respective purchase price and it creates the chances of errors. This method helps to reduce the burden of recording inventory related transactions and human errors. It is the simplest process of tracking inventory expenses. While retrieving the units, the company does not need to track the original cost of inventory before pricing it to make it available for sale. It helps users to mark up the average price of units and this makes picking and pricing inventory easy.

Eliminate the task of separating inventory items

Average cost method is considered as a better inventory valuation method than LIFO and FIFO when applying it to value products that are not easy to separate or impossible to distinguish from others. For instance, iron ore, wheat, oil, etc. always purchased in batches are some products that are not possible to separate one batch from another. Here, the average cost method treats each batched of inventory without separating them by considering different batches purchased at different times. Therefore, this method is much more relevant and suitable for the companies to operate by using these kinds of inventories.

Automatic adjustment of price fluctuation

This method uses to adjust the effects of price fluctuation automatically. Suppose a company has closing inventory that belongs to the last batch purchased at the end of a financial year when prices increased suddenly but it is expected that the price becomes normal again average cost method manages it a much better way than other methods because it spreads the price hike effect and thus, normalise the sudden fluctuations.

Cost saving

Among the three methods of inventory valuation, the average cost method is the most cost effective method because it requires less cost and time to calculate inventory value than other methods. Because labor cost stands as a vital expense in every company, reducing the time spent on valuing inventory is cost effective for the company as well as it frees up the employees of the company to focus on other tasks. This labor cost savings along with efficient utilization of time offset the potential losses which use to occur as a result of computing the value of expensive inventory items at a price similar to the low cost items. For more information you can check Assignment Help Australia.

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