Breaking Down Average Cost Method for Inventory

Post on Tuesday, May 22nd, 2018 in Accounting

Average cost method, or weighted average, is one of the inventory valuation methods that help to calculate the cost of goods sold.

The cost of goods sold, or COGS, includes both the costs of the inventory items and additional expenses, such as shipping costs, customs fees and packaging. Average costing assigns all inventory items a single cost price derived from the average cost of all those items. The average cost method is an alternative to FIFO or LIFO, which use the actual prices paid for each unit, even if the costs change.

In this article, we are going to explain the average cost inventory calculation in more detail as well as highlight the pros and cons of this method.

The average cost calculation formula is as follows:

To calculate average cost, take the cost of goods available for sale and divide it by the total number of items from the beginning inventory and purchases.

For example, a clothing store has 15 identical pairs of jeans in stock. Five of them cost $10 per unit, the next five cost $ 11 per unit and the remaining five cost $ 12 per unit. The average cost will be as follows:

$10 x 5 + $11 x 5 + $12 x 5 / 15 = $11

This means that the cost of all 15 pairs is treated as if they were $11 each. Therefore, $11 is the average cost for this item.

Wondering when to apply the weighted average method?

It’s suitable for the following situations:

  • Identical inventory items – If you have large volumes of identical items that are moving fast through your inventory system, you can use the weighted average method to save time on tracking each item individually.
  • Long-term planning – If you use average cost for long-term purposes, such as budget planning, then the weighted average method will be helpful in case of raw material cost fluctuations.

The average costing inventory method is typically used in the following sectors:

  • Manufacturers (clothes, chemicals, pharmaceuticals, etc) – Inventories of manufacturers often involve mixed batches of the same product. As a result, it becomes difficult to distinguish between the older and the newer items in the same batch. The average cost method makes it easier to account for such items.
  • Oil companies – Same as with manufacturers, batches of oil and petrol can be mixed, so the weighted average method is the best one here as it helps to avoid confusion between the items within a batch.
  • Food and agriculture – Agricultural and food products are collected in large amounts, and it is difficult to differentiate them individually. Weighted average costing simplifies the accounting for these types of items.

 

Average Cost Method Inventory Advantages

The average cost method has the following benefits:

  • Ease of use – A simple formula makes it quite easy to calculate the average cost. It can be calculated even without an inventory management system.
  • Saved time – When you pick inventory items, you do not have to track their original cost before pricing them. You can just mark up the average price of the items.
  • Cost efficiency – Due to its simplicity, the average costing method is also the most cost efficient method as it requires little input.
  • Compliance with the International Financial Reporting Standards – If your business operates internationally, it needs to comply with the International Financial Reporting Standards (IFRS). The average cost method allows such compliance, unlike LIFO, which reduces taxation figures and thus can lead to problems with international tax authorities.
  • Smoothened price fluctuations – When prices fluctuate around an average, average costing method will help you be more confident that you are not underpricing.
  • Consistency – With the weighted average method, the product cost of your inventory will be consistent. After the product cost is calculated, that cost can be used for all inventory items. This includes the cost used for the ending inventory value and the cost of goods sold. Alternative methods require accountants to use a variety of costs, depending on individual costs incurred with each transaction. Besides, accountants do not need to process the detailed records for each purchase – they need to process records only for the totals.
  • More accurate comparison between periods – If you need to review your profits per accounting periods, you will get more accurate and realistic figures with average costing.

Average Cost Method Inventory Disadvantages

The average cost method has the following drawbacks:

  • Suitable only for identical items – Unfortunately, you cannot use average cost for inventory in industries where the products are not identical. For example, the electronics industry involves devices that have lots of different parameters, such as color, size, model, and so on. It means that such items are not identical and their prices can have significant differences. 
  • Can affect reporting – If the cost of a stocked item fluctuates, it can lead to errors in reported sales profit. Your pricing may not recover the costs of items that are more expensive, which can lead to loss with your sales price. You can even end up discontinuing the item and never recover the losses.
  • Product batches should be the same in amount – If the amount of inventory items per batch is inconsistent, then the costs assigned to each product will vary the same way, leading to inaccurate cost values.
  • Aggregated costs – Average cost method involves processing all costs as a single transaction before distributing costs across all items. For example, work-in-process inventory costs, which are incurred by manufactured items that have not yet been completed, are processed together with material costs. This can create confusion and result in inaccurate figures.
  • Variable prices – If you use the cost + pricing strategy to price your products, then each new purchase will be made at a different rate than the previous one, changing the sales price as well. Such frequent changes may annoy your customers and make it difficult to quote prices to prospective clients.
  • Rounding off errors – Average cost calculations typically round off the resulting figures, which can also result in reporting errors.

How Will You Determine Your Average Inventory Cost?

Now you know what the average cost method is, as well as the advantages and disadvantages it can bring your business from an inventory management perspective.

Please be aware that after you choose your inventory costing method, you should always follow this method in the course of your business. For example, if you choose the weighted average method for inventory valuation, you will not be able to switch to FIFO or LIFO later. Therefore, it is crucial that you carefully analyze your business and its needs before choosing your preferred method.

Adam is the Assistant Director of Operations at Dynamic Inventory. He has experience working with retailers in various industries including sporting goods, automotive parts, outdoor equipment, and more. His background is in e-commerce internet marketing and he has helped design the requirements for many features in Dynamic Inventory based on his expertise managing and marketing products online.

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