How to Calculate Average Cost in Accounting?
Understand the weighted-average cost method in accounting to accurately value inventory and determine cost of goods sold.
The weighted-average cost method is an inventory valuation technique that provides a smoothed cost figure for inventory items, especially when identical goods are purchased at varying prices. Its purpose is to assign a consistent cost to both unsold inventory and goods sold. This method simplifies valuation by blending different purchase costs into a single average.
Understanding the Inputs for Average Cost
Before calculating the weighted-average cost, two pieces of information must be identified: the total cost of all goods available for sale and the total number of units available for sale. The total cost of goods available for sale represents the cumulative expense for all inventory a business could potentially sell. This amount is derived by adding the cost of beginning inventory to the cost of all purchases made throughout the period.
Beginning inventory refers to goods unsold from the previous accounting period. Purchases include all new inventory acquisitions, encompassing their purchase price and any directly attributable costs like freight or shipping. The total units available for sale are determined by summing units in beginning inventory with all units acquired through purchases. These two totals form the basis for computing the average cost per unit.
Calculating the Weighted-Average Cost
Calculating the weighted-average cost involves division once inputs are gathered. The formula is: Weighted-Average Cost = (Total Cost of Goods Available for Sale) / (Total Units Available for Sale). This calculation yields a single average cost per unit applied uniformly. This method benefits businesses dealing with large volumes of indistinguishable inventory items, where tracking each individual unit’s cost would be impractical.
Consider a business that started with 100 units in beginning inventory at a cost of $500. During the period, it made two purchases: 200 units for $1,200, and later, 150 units for $1,050. To calculate the total cost of goods available for sale, add the beginning inventory cost to the purchase costs: $500 (beginning inventory) + $1,200 (first purchase) + $1,050 (second purchase), totaling $2,750. Next, the total units available for sale are determined by adding the beginning inventory units to the purchased units: 100 units (beginning inventory) + 200 units (first purchase) + 150 units (second purchase), resulting in 450 units. Using the formula, the weighted-average cost per unit is $2,750 / 450 units, approximately $6.11 per unit.
Using Average Cost in Inventory and Cost of Goods Sold
Once the weighted-average cost per unit is determined, this single average cost is applied to value both ending inventory and the cost of goods sold. This consistent application simplifies financial reporting. For instance, if 300 units were sold from the previous example, the cost of goods sold would be calculated by multiplying units sold by the weighted-average cost per unit: 300 units $6.11 per unit, equaling $1,833.00.
To determine ending inventory value, remaining units are multiplied by the same weighted-average cost. If 450 units were available for sale and 300 units were sold, 150 units remain in ending inventory. The value of this ending inventory would be 150 units $6.11 per unit, resulting in $916.50. This method provides a balanced valuation that smooths out price fluctuations, offering a consistent representation of inventory costs on financial statements.