What Is the Average Cost Method & How Does It Work?
Learn the average cost method. Uncover how this fundamental accounting technique simplifies asset valuation and cost tracking across various financial contexts.
The average cost method is an accounting technique used to determine the cost assigned to items sold or in inventory. This approach calculates a weighted average cost for all identical items available, regardless of their individual purchase prices. It provides a smoothed-out cost figure, useful when dealing with a high volume of similar items acquired at varying costs. It simplifies valuation by treating all units as having the same average cost.
Understanding the Calculation
The average cost method calculates a single average price for all available units. This calculation begins by summing the total cost of all units available. The total number of units is also determined. The average cost per unit is then derived by dividing the total cost by the total number of units. This weighted average cost is applied to all units.
To illustrate, consider a scenario where a business has an initial stock of 100 units purchased at $10 each, totaling $1,000. Later, it acquires an additional 50 units at $12 each, costing $600. The total cost of all available units is now $1,000 + $600 = $1,600, and the total number of units is 100 + 50 = 150. The average cost per unit would be $1,600 divided by 150 units, resulting in approximately $10.67 per unit. This average cost is then used for any subsequent transactions until new purchases alter the total cost and unit count, necessitating a recalculation of the average.
Application in Inventory Valuation
In inventory management, the average cost method values both goods sold and remaining inventory. Under this method, all items in inventory are assigned the same average cost, calculated for all goods available during an accounting period. This approach simplifies accounting, especially for businesses handling large volumes of identical products where tracking individual unit costs is impractical.
For example, if a company has a beginning inventory of 200 units at an average cost of $25 per unit, and then purchases another 300 units at $30 per unit, the total cost of goods available would be (200 $25) + (300 $30) = $5,000 + $9,000 = $14,000. The total units available are 200 + 300 = 500 units. The new average cost per unit becomes $14,000 / 500 = $28. If the company then sells 350 units, the Cost of Goods Sold (COGS) would be 350 units $28/unit = $9,800. The ending inventory would consist of the remaining 150 units (500 – 350), valued at 150 units $28/unit = $4,200.
Application in Investment Cost Basis
The average cost method is used to determine the cost basis of investments, particularly for shares of mutual funds or stocks held in taxable accounts. When an investor sells holdings, this method calculates the cost of the sold shares by averaging the purchase price of all shares owned. This average cost basis determines capital gain or loss for tax reporting.
For instance, if an investor buys 10 shares of a mutual fund at $50 each and later buys another 10 shares at $60 each, the total cost is $500 + $600 = $1,100 for 20 shares. The average cost per share is $1,100 / 20 = $55. If the investor sells 5 shares at $70 each, the cost basis for those 5 shares would be 5 $55 = $275. The capital gain realized on this sale would be $350 (sale proceeds) – $275 (cost basis) = $75. This method can simplify record-keeping for investors, as it avoids tracking individual share lots.