How to Calculate Average Cost in Accounting
Uncover a core accounting method for consistently valuing inventory and sales, providing a practical way to manage fluctuating costs.
Average cost accounting is a method businesses use to value their inventory and determine the cost of goods sold. This approach simplifies financial reporting by assigning an average cost to all units of a particular item. It is particularly useful for companies that deal with large volumes of identical items.
What Average Cost Accounting Is
Average cost accounting, also known as the weighted-average method, operates on the principle that all units of inventory available for sale during a period are indistinguishable and thus share the same average cost. This method aggregates the cost of all inventory units, including both beginning inventory and new purchases. Companies often choose this method when their inventory consists of many similar items that are difficult to track individually, such as bulk commodities or interchangeable goods.
This approach reflects the assumption that inventory units are commingled and lose their specific identity once acquired. For instance, a hardware store selling thousands of identical screws would find it impractical to track the exact purchase price of each screw sold. It aligns with generally accepted accounting principles (GAAP) and is accepted by the Internal Revenue Service (IRS) for tax purposes, as outlined in regulations such as Treasury Regulation 1.471-2.
Calculating the Weighted-Average Cost
Calculating the weighted-average cost per unit involves combining the cost and quantity of all available inventory. The formula for this calculation is the total cost of beginning inventory plus the total cost of all purchases, divided by the total units in beginning inventory plus the total units purchased. This method avoids the need to identify which specific units were sold, simplifying record-keeping for businesses with high inventory turnover.
Consider a company that began the month with 100 units in inventory, each costing $10, totaling $1,000. On the 5th of the month, the company purchased an additional 200 units at $12 each, costing $2,400. Later, on the 15th, another 300 units were bought for $11 each, totaling $3,300. To find the weighted-average cost, first sum the total cost of all units available for sale. This includes the initial $1,000, plus $2,400, and $3,300, resulting in a total cost of $6,700.
Next, sum the total number of units available for sale. This includes the initial 100 units, plus 200 units, and 300 units, for a total of 600 units. Finally, divide the total cost of $6,700 by the total units of 600. This calculation yields a weighted-average cost of approximately $11.17 per unit ($6,700 / 600 units).
Applying Average Cost to Inventory and Sales
Once the weighted-average cost per unit is calculated, this figure is then used to determine the value of a company’s ending inventory and its Cost of Goods Sold (COGS). This consistent application ensures that financial statements accurately reflect the average cost of items.
To calculate the value of ending inventory, the weighted-average cost per unit is multiplied by the number of units remaining in inventory at the end of the period. For instance, if the company from the previous example had 150 units left in inventory at the end of the month, the ending inventory value would be $1,675.50 (150 units x $11.17 per unit).
Similarly, the Cost of Goods Sold is determined by multiplying the weighted-average cost per unit by the total number of units sold during the period. If the company sold 450 units during the month (600 units available – 150 units in ending inventory), the COGS would be $5,026.50 (450 units x $11.17 per unit).
When Average Cost Accounting Is Used
Average cost accounting is particularly well-suited for businesses that deal with large quantities of identical and interchangeable goods. Examples include companies in the agricultural sector, such as grain elevators, or those dealing with bulk liquids like oil and chemicals. Hardware stores or grocery stores, where specific items like bags of flour or boxes of nails are indistinguishable from one another, also commonly employ this method.
This method is also favored when the cost of tracking individual inventory items outweighs the benefits. For instance, a business selling thousands of low-value, high-volume items would incur significant administrative costs trying to implement a more specific identification method. The weighted-average method simplifies inventory management and valuation in such scenarios.