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Average Cost Flow Assumption

Average Cost Flow Assumption
BusinessCorporate Finance and AccountingFinancial Statements

What Is Average Cost Flow Assumption?

Average cost flow assumption is a calculation companies use to assign costs to inventory goods, cost of goods sold (COGS), and ending inventory. An average is taken of every one of the goods sold from inventory over the accounting period and that average cost is assigned to the goods.

Average cost flow assumption is likewise called "the weighted average cost flow assumption."

Grasping Average Cost Flow Assumption

Inventory addresses every one of the completed goods or materials utilized in production that a company has possession of. When sold, these things are then discounted on the income statement as COGS — an important measurement used to measure profitability and assess how efficient a company is at dealing with its labor and supplies in the production cycle.

Companies have several methods at their disposal to generally figure out which costs are eliminated from a company's inventory and reported as COGS. One of them is the average cost flow assumption. This specific approach takes an average of the cost of things sold, leading to a mid-range COGs figure.

The average cost flow assumption expects that all goods of a certain type are interchangeable and just vary in purchase price. The purchase price differentials are credited to outer factors, including inflation, supply, or demand.

Under the average cost flow assumption, the costs are all additional together, then, at that point, separated by the total number of units that were purchased. The number of units sold can be increased by the average price per unit to lay out COGS and the ending inventory — the value of goods still ready to move and held by a company toward the finish of a accounting period.

Illustration of Average Cost Flow Assumption

We should accept that Wexel's Widgets Inc. uses the average cost flow assumption while assigning costs to inventory things. During the accounting period, Wexel sells 25 gadgets from bucket A, every one of which cost $25 to deliver; 27 gadgets from bucket B, every one of which cost $27 to deliver; and 30 gadgets from bucket C, every one of which cost $30 to create.

The gadgets are interchangeable, just varying in the cost of production, due to an increase in the cost of the plastic dangerous utilized in the manufacturing system. To register the total COGS, Wexel uses the average cost flow assumption method. It works out the cost of every gadget as follows: [(25x$25) + (27x$27) + (30x$30)]/(25+27+30).

Average Cost Flow Assumption versus FIFO versus LIFO

Companies generally utilize one of three methods to assign costs through various production phases. Alternatives to the average cost flow assumption include:

FIFO

The First-In, First-Out (FIFO) method accepts that the principal unit advancing into inventory is sold first. FIFO is generally best in times of rising prices as the costs recorded are low, and income is higher.

LIFO

The Last-In, First-Out (LIFO) method adopts the contrary strategy, accepting that the last things to show up in inventory are sold first. This specific accounting technique is generally adopted when tax rates are high in light of the fact that the costs assigned will be higher and income will be lower.

Important

The method used to assign costs to inventory and COGS can have a big bearing on a company's key financials, reported profitability, and tax obligations.

Benefits and Disadvantages of Average Cost Flow Assumption

The average cost flow assumption kills the need to follow every individual thing, which can prove to be useful, especially when there are large volumes of comparative goods moving through inventory. This technique requires negligible labor, is a lot less expensive than other inventory cost methods to apply, and, in theory, is less inclined to control income.

However, there are downsides. The average cost flow assumption accepts that all units are indistinguishable, even however that not could constantly be the case. Fresher groups of a similar product or material, for example, may be marginally unrivaled than more established ones, and, subsequently, may command a higher price.

Special Considerations

Generally accepted accounting principles (GAAP), a common set of accounting principles, standards, and procedures that all public companies in the U.S. are required to maintain, champions consistency. Financial statements are expected to be effectively comparable starting with one accounting period then onto the next to simplify life for investors.

That means that it is absurd to often cleave and change inventory costing methods. Standard adjustments are disliked and, when vital, must plainly be highlighted in the company's footnotes to the financial statements.

Highlights

  • An average is taken of every one of the goods sold from inventory over the accounting period and that average cost is assigned to the goods.
  • Average cost flow assumption is a calculation companies use to assign costs to inventory goods, cost of goods sold (COGS), and ending inventory.
  • This method is commonly employed when inventory things are so like each other that it becomes challenging to assign a specific cost to an individual unit.