Average Cost Method
What Is the Average Cost Method?
The average cost method assigns a cost to inventory things in view of the total cost of goods purchased or created in a period isolated by the total number of things purchased or delivered. The average cost method is otherwise called the weighted-average method.
Figuring out the Average Cost Method
Organizations that sell products to customers need to deal with inventory, which is either bought from a separate manufacturer or delivered by the company itself. Things previously in inventory that are sold off are recorded on a company's income statement as cost of goods sold (COGS). The COGS is an important figure for organizations, investors, and analysts as it is deducted from sales revenue to decide gross margin on the income statement. To compute the total cost of goods sold to consumers during a period, various companies utilize one of three inventory cost methods — first in first out (FIFO), last in first out (LIFO), or average cost method.
The average cost method involves a simple average of all comparative things in inventory, paying little heed to purchase date, followed by a count of definite inventory things toward the finish of a accounting period. Increasing the average cost per thing by the last inventory count gives the company a figure for the cost of goods ready to move by then. A similar average cost is likewise applied to the number of things sold in the previous accounting period to decide the cost of goods sold.
Illustration of the Average Cost Method
For instance, think about the following inventory ledger for Sam's Electronics:
|Number of items
|Cost per unit
Benefits of the Average Cost Method
The average cost method requires insignificant labor to apply and is, consequently, the least costly of the relative multitude of methods. Notwithstanding the simplicity of applying the average cost method, income can't be essentially as handily controlled likewise with the other inventory costing methods. Companies that sell products that are indistinct from one another or that find it challenging to track down the cost associated with individual units will like to utilize the average cost method. This additionally helps when there are large volumes of comparable things moving through inventory, making it tedious to follow every individual thing.
One of the core parts of U.S. generally accepted accounting principles (GAAP) is consistency. The consistency principle requires a company to take on an accounting method and follow it reliably starting with one accounting period then onto the next. For instance, organizations that embrace the average cost method need to keep on involving this method for future accounting periods. This principle is in place for the simplicity of financial statement users so that figures on the financials can measure up year over year. A company that changes its inventory costing method must feature the change in its footnotes to the financial statements.
- When a company chooses an inventory valuation method, it necessities to stay reliable in its utilization to be consistent with generally accepted accounting principles (GAAP).
- The average cost method is one of three inventory valuation methods, with the other two common methods being earliest in, earliest out (FIFO) and last in first out (LIFO).
- The average cost method utilizes the weighted-average of all inventory purchased in a period to assign value to cost of goods sold (COGS) as well as the cost of goods still ready to move.