How to Calculate Average Cost of Goods Sold
Understand the weighted-average method for inventory costing and accurately determine your Cost of Goods Sold for better financial insights.
Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce the goods it sells. It includes direct materials and labor, but excludes indirect expenses like marketing or administrative costs. COGS is a direct expense on a company’s income statement, positioned immediately below revenue. Subtracting COGS from revenue yields a company’s gross profit, which is a significant indicator of its financial performance and operational efficiency.
Understanding Cost Components
Calculating Cost of Goods Sold requires understanding several key components that form the basis of inventory valuation. These elements provide the necessary information regardless of the inventory costing method used.
Beginning inventory refers to the value of goods a company has on hand at the start of an accounting period. This figure represents products that were purchased or manufactured in a previous period but remained unsold. It serves as the starting point for tracking inventory movement within the current period.
Purchases made during the period include the cost of all new goods acquired for resale. This figure encompasses the invoice price of the goods, along with any freight-in costs, which are expenses incurred to transport the goods to the company’s location. Conversely, purchase returns and allowances, which reduce the cost of goods due to damaged or returned items, and purchase discounts, obtained for early payment, reduce the total cost of these acquisitions. These adjustments result in a net purchases figure, reflecting the true cost of goods added to inventory.
Ending inventory is the value of unsold goods remaining at the close of an accounting period. A physical count is often performed to determine the quantity of goods still on hand. This component is crucial because it represents the portion of goods available for sale that were not sold, and its valuation directly impacts the calculated COGS for the period.
The Average Cost Inventory Method
The average cost inventory method, also known as the weighted-average method, is an approach to valuing inventory and calculating Cost of Goods Sold. This method operates on the principle that all goods available for sale during a period are indistinguishable and should be valued at their average cost. It offers a practical solution for businesses dealing with high volumes of similar, interchangeable products where tracking individual unit costs might be impractical.
Businesses often favor this method for its simplicity and its ability to smooth out the effects of price fluctuations on inventory costs. When product costs vary, using an average cost helps to mitigate the impact of extreme price changes on financial statements. This approach provides a more consistent representation of profitability, particularly in environments where inventory is commingled and specific identification of units is not feasible.
To apply this method, the first step involves calculating the average cost per unit. This is determined by dividing the total cost of all goods available for sale by the total number of units available for sale. Once the average cost per unit is established, the Cost of Goods Sold is then calculated by multiplying this average cost by the number of units sold during the period. The same weighted-average cost is also applied to determine the value of the ending inventory.
Step-by-Step Calculation Example
Applying the average cost method to calculate Cost of Goods Sold involves a clear, sequential process. Consider a hypothetical scenario for a business at the end of an accounting period. This business began the period with an inventory of 100 units at a cost of $10 per unit, totaling $1,000.
During the period, the business made two purchases. The first purchase consisted of 150 units at $12 per unit, costing $1,800. A second purchase later in the period involved 200 units at $13 per unit, amounting to $2,600. The total number of units available for sale during the period is the sum of the beginning inventory and all purchases: 100 units + 150 units + 200 units, resulting in 450 units available.
Next, the total cost of goods available for sale is determined by adding the cost of the beginning inventory to the cost of all purchases. This calculation yields $1,000 (beginning inventory) + $1,800 (first purchase) + $2,600 (second purchase), totaling $5,400. With the total cost and total units available, the weighted-average cost per unit is calculated by dividing the total cost of goods available for sale by the total units available for sale. This results in $5,400 / 450 units, which equals $12 per unit.
Assuming the business sold 300 units during the period, the Cost of Goods Sold is calculated by multiplying the number of units sold by the weighted-average cost per unit. Therefore, 300 units sold multiplied by $12 per unit equals $3,600. This $3,600 represents the direct cost of the goods that were sold.
To determine the value of ending inventory, the number of unsold units is multiplied by the same weighted-average cost per unit. If 300 units were sold from the 450 units available, then 150 units remain in ending inventory. Multiplying 150 units by the $12 weighted-average cost per unit results in an ending inventory value of $1,800.