Average Cost Method: Definition and Formula With Example

The Average Cost Method, also known as the weighted average cost method, is an inventory valuation technique used to determine the cost of goods sold and the value of ending inventory. Under this method, the cost of all units available for sale during a specific period is averaged, and this average cost is then applied to both the units sold and the units remaining in inventory. It assumes that all inventory items are interchangeable or identical, and it smooths out price fluctuations over time.

This method is particularly useful for businesses that deal with homogeneous goods—items that are indistinguishable from one another, such as oil, grains, or certain raw materials. Unlike other inventory valuation methods like First-In, First-Out (FIFO) or Last-In, First-Out (LIFO), the Average Cost Method does not prioritize the order in which goods are purchased or sold. Instead, it focuses on creating a uniform cost per unit, making it a straightforward and equitable approach.

The Average Cost Method is recognized under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), making it a compliant choice for financial reporting in many jurisdictions. It is commonly applied in industries where inventory items have minimal variation in cost or where tracking individual unit costs would be impractical.

The Formula for the Average Cost Method

The formula for calculating the average cost per unit under this method is simple yet effective. It is expressed as:

Average Cost per Unit = Total Cost of Goods Available for Sale ÷ Total Units Available for Sale

Where:

Total Cost of Goods Available for Sale = The sum of the cost of beginning inventory plus the cost of all purchases made during the period.
Total Units Available for Sale = The sum of the units in beginning inventory plus the units purchased during the period.

Once the average cost per unit is determined, it is used to calculate:

Cost of Goods Sold (COGS) = Average Cost per Unit × Number of Units Sold
Ending Inventory Value = Average Cost per Unit × Number of Units Remaining in Inventory

This formula ensures that the cost is distributed evenly across all units, regardless of when they were acquired or at what price.

How the Average Cost Method Works

To understand how the Average Cost Method operates, let’s break it down into steps:

Determine the Total Cost and Units Available: At the start of an accounting period, a business records its beginning inventory (both in units and cost). Throughout the period, it tracks all additional purchases, adding their costs and quantities to the total.
Calculate the Average Cost per Unit: Using the formula above, the business divides the total cost by the total units to find the average cost.
Apply the Average Cost: This average cost is then multiplied by the number of units sold to calculate COGS and by the number of units remaining to value the ending inventory.
Repeat for Each Period: In a perpetual inventory system, the average cost is recalculated after each purchase. In a periodic system, it’s calculated at the end of the period.

The method’s simplicity lies in its averaging mechanism, which eliminates the need to track the specific cost of each unit sold. However, it assumes that inventory costs remain relatively stable or that fluctuations are not significant enough to distort financial reporting.

Example of the Average Cost Method

Let’s walk through a practical example to see the Average Cost Method in action.

Scenario: A small retail business sells widgets. At the beginning of January, the business has 100 widgets in inventory, purchased at $10 each. During the month, it makes two additional purchases:

January 10: 150 widgets at $12 each
January 20: 200 widgets at $14 each

By the end of January, the business sells 300 widgets. We’ll calculate the COGS and ending inventory value using the Average Cost Method.

Step 1: Calculate Total Cost of Goods Available for Sale

Beginning Inventory: 100 widgets × $10 = $1,000
Purchase 1: 150 widgets × $12 = $1,800
Purchase 2: 200 widgets × $14 = $2,800
Total Cost = $1,000 + $1,800 + $2,800 = $5,600

Step 2: Calculate Total Units Available for Sale

Beginning Inventory: 100 widgets
Purchase 1: 150 widgets
Purchase 2: 200 widgets
Total Units = 100 + 150 + 200 = 450 widgets

Step 3: Calculate Average Cost per Unit

Average Cost per Unit = $5,600 ÷ 450 = $12.44 (rounded to two decimal places)

Step 4: Calculate Cost of Goods Sold (COGS)

Units Sold: 300 widgets
COGS = 300 × $12.44 = $3,732

Step 5: Calculate Ending Inventory Value

Units Remaining = 450 – 300 = 150 widgets
Ending Inventory = 150 × $12.44 = $1,866

Summary:

Cost of Goods Sold: $3,732
Ending Inventory: $1,866
Total (COGS + Ending Inventory) = $3,732 + $1,866 = $5,598 (Note: Slight variance due to rounding; the total matches the $5,600 cost of goods available for sale when unrounded values are used.)

This example demonstrates how the Average Cost Method distributes costs evenly, providing a consistent per-unit value regardless of purchase price variations.

Advantages of the Average Cost Method

The Average Cost Method offers several benefits, making it a popular choice for many businesses:

Simplicity: It requires minimal record-keeping compared to FIFO or LIFO, as it doesn’t track the order of inventory movement.
Smooths Price Fluctuations: By averaging costs, it reduces the impact of sudden price spikes or drops, leading to more stable financial reporting.
Fairness: It allocates costs uniformly, which can be seen as equitable when goods are identical or interchangeable.
Compliance: It aligns with GAAP and IFRS, ensuring it meets regulatory standards for financial reporting.
Adaptability: It works well in both periodic and perpetual inventory systems, offering flexibility to businesses of varying sizes.

For companies with large inventories of similar items, such as wholesalers or manufacturers of bulk goods, this method simplifies accounting processes while maintaining accuracy.

Limitations of the Average Cost Method

Despite its advantages, the Average Cost Method has some drawbacks:

Lack of Precision: It doesn’t reflect the actual flow of goods, which can be a disadvantage in industries where costs vary significantly over time.
Tax Implications: In periods of rising prices, it may result in higher taxable income compared to LIFO, as it doesn’t allow businesses to match higher recent costs against revenue.
Not Ideal for Unique Items: It’s less suitable for businesses dealing with high-value, distinct items (e.g., jewelry or cars), where tracking specific costs is more appropriate.
Perpetual System Complexity: In a perpetual inventory system, recalculating the average cost after every purchase can become cumbersome if transactions are frequent.

These limitations suggest that while the Average Cost Method is effective for certain scenarios, it may not suit every business model or industry.

Comparison with FIFO and LIFO

To fully appreciate the Average Cost Method, it’s helpful to compare it with FIFO and LIFO:

FIFO (First-In, First-Out): Assumes the earliest goods purchased are sold first. In rising price environments, FIFO results in lower COGS and higher ending inventory values, potentially reducing taxable income.
LIFO (Last-In, First-Out): Assumes the most recently purchased goods are sold first. In inflationary periods, LIFO increases COGS and lowers ending inventory, often leading to tax savings. However, LIFO is not permitted under IFRS.
Average Cost Method: Falls between FIFO and LIFO in terms of COGS and inventory valuation, offering a middle ground that avoids extremes.

The choice between these methods depends on a company’s goals, industry practices, and regulatory requirements.

Practical Applications in Modern Accounting

In today’s digital age, the Average Cost Method is often implemented through accounting software, which automates calculations and updates averages in real time. Small businesses, retailers, and manufacturers frequently adopt this method due to its ease of use and compatibility with inventory management systems. For example, a grocery store selling bulk rice or a hardware store stocking nails might use the Average Cost Method to streamline their financial reporting.

Additionally, the method’s compliance with international standards makes it a go-to option for multinational companies seeking consistency across jurisdictions. However, businesses must weigh its benefits against their specific needs, especially in volatile markets where cost trends could significantly impact profitability.

Conclusion

The Average Cost Method is a versatile and widely accepted approach to inventory valuation, offering a balanced way to assign costs and calculate financial metrics. Its formula—dividing the total cost of goods available for sale by the total units—provides a clear and consistent average cost per unit, which is then applied to both COGS and ending inventory. As demonstrated in our example, it simplifies accounting for businesses with homogeneous inventory, smoothing out price variations and ensuring compliance with major accounting standards.