Average Cost Inventory Method: Definition, Formula & Method
You have a business, and just like many business owners, you want to improve your bottom line. You will need evaluation methods most common in eCommerce accounting to achieve your goal. In this post, you will understand what the account inventory cost method is and what it involves. In the end, you will know how to calculate the average cost, how your business can benefit from it, and its application.
Costing methods overview
If you own a business, you may have a manager or handle it on your own. As such, you need cost accounting to help you make the decisions. Cost accounting does not necessarily mean you have to make comparisons with other businesses. The idea is to make the information relating to your choices, especially with strategies. If you handle this information, you add value to your business or the organization you are working for, be it a bank, non-profit organization, private business, and so on. The accounting information will help you make decisions, especially with your business’s performance or the company you are working for.
There are four accepted financial costing methods. They include
- Average cost inventory method
- First-in, first-out (FIFO)
- Last in First out (LIFO)
- Specific identification
Today, we are only concentrating on the average cost inventory method. Henceforth, it will be easy to manage your inventory as you attract more profits by optimizing the entire process. So, if you are ready, grab a drink, sit, relax, and read this fascinating piece.
Average Cost Inventory Method; Definition
It is also known as the weighted average cost method (WAC). It calculates the cost of ending an inventory against the cost of the goods sold in a particular period based on the weighted average cost per unit of inventory. The average cost method is one of the three methods of inventory evaluations, with the other two being the First in First (FIFO) and the Last in First (LIFO). Once your business chooses an inventory valuation method, it must use it consistently to comply with the generally accepted accounting principles (GAAP).
The average cost inventory method follows this formula.
Weighted Average Unit Cost = Total Cost of Inventory / Total Units in Inventory
Understanding the Average Cost Method
If you are yet to understand this method, let’s dissect it further.
Let’s say you have a business, right? It means you are selling products to your customers, and as such, you must deal with an inventory. Otherwise, how will you keep track of your progress, and more so, profits and possible losses? You can either get it from the manufacturer of the goods you are selling or generate it from your business. If you sell items previously in your inventory, you must record them in your company’s income statement under the Cost of goods sold (COGS).
The cost of goods sold is crucial to you, investors, your business, and analysts. It is derived from the sales revenue to determine the gross margin on the income statement. Your business and other businesses can use the average cost inventory or the other two methods (FIFO and LIFO) to ascertain the cost of goods sold.
The average cost method utilizes the average of every similar good in the inventory irrespective of the date of purchase. It is then followed by the count of inventory items at the end of the accounting duration. To get the figure of the cost of goods available for sale, you multiply the average price per item by the final inventory count. You can apply the same average cost to the number of things you sell during the previous accounting period and still determine the cost of goods sold.
Example of an average cost method
For a better perspective, let’s look at an example, shall we?
Let’s say your business, Furniture Hub, has a cost of goods available for sale beginning 02/01/2020 amounting to $5000 (for 200 units). You have 200 units for sale, and you sell 50 units. You have an ending inventory of 150 units. Now, every unit costs $25 (5000/200). The value of the ending inventory on your balance sheet is $3,750. So, your cost of goods sold should be $1250 because you sold 50 units at $25 each.
Number of units = 200
Cost per unit = $25
Cost of goods available for sale beginning January = $5,000
Number of units sold = 50
Ending Inventory = 150
So, 50 units x $25 (cost per unit) = $1250
Ending inventory balance sheet = $5000-$1,250 = $3,750
Example 2: Weighted Average Cost method in a periodic inventory system
Let’s have another tabulated example and apply the formula to understand the Weighted Average Cost. Dates of the same period and the items involved have been included.
So, we shall use the Weighted Average Unit Cost = Total Cost of Inventory / Total Units in inventory
The total cost of the units, which is $19000, will be divided by the total number of units, 600.
Therefore; 19000÷600= $31.7
The periodic inventory system is used when there is no continuous record of any changes. you can record your annual purchases in the account, which is a ledger that lists every inventory and the costs involved
Now you have an idea of how to navigate the average cost method, but what are the benefits involved? Let’s look at a few of them.
Using the Average cost inventory method (WAC) in a perpetual inventory
If you apply the weighted average cost method in a perpetual inventory, it’s easier for you to track all the inventories and cost of goods sold. The perpetual inventory system gives you the timely information necessary to manage inventory levels. However, this can be an expensive method for you. The weighted average cost in this system is referred to as the moving average cost method. So, using the information tabulated above, for the sale of the units sold in January, we can allocate an average cost of $31.7
as such 400 units x $31.7= $12,680 in COGS
Therefore, $19000 – $12680= $6,320 in ending inventory
Merits of the average cost method
When you choose to use the average cost method you:
- Cut on the labor, meaning it’s a least expensive method
- Cannot manipulate it as opposed to other inventory costing methods even though it’s simple
- Can use it if your business is indistinguishable from other companies and businesses to help you find the cost associated with individual units
- The average costing method is necessary if you have large volumes of similar items within your inventory, which would otherwise be hard to monitor every item
- When you use this method during price hikes, the cost of goods sold will be more than the one obtained through FIFO
- Can use the average cost inventory method for long-term purposes like budgeting in case of cost fluctuations
- Comply with the international financial reporting standards, especially if your business is international as opposed to other methods like LIFO, which cuts on taxation figures. This might put you at loggerheads with international tax authorities
- Will be more confident in how you price your items especially when prices fluctuate around an average
- Become consistent with the product cost of your inventory. Once you calculate the product cost, it can be used for all inventory systems. This incorporates the cost of the ending inventory value and the cost of goods sold
- You will get more accurate and realistic numbers with average costing, especially if you compare periods and review your profits
- Have less paperwork since the method uses a single calculation to determine the average value of your stock items. Since the value of the item is the same, you do not have to maintain a detailed inventory of purchasing records, which translates to less paperwork
Before we can even go further, FIFO and LIFO have been mentioned several in the post, but what are they? If you are going to understand the average costing method better and distinctively, we must look at them. Let’s start with.
The first in first method involves the first item purchased being the first one to be sold. It implies at the buying cost of the first item is the cost of the first item sold. This results in closed inventory that you report on the balance sheet showing the approximate current cost, whose value is based on the most recent purchase. So, when prices are rising (Inflationary environment), the ending inventory will be more as opposed to other methods.
The last in first out method involves the cost of the previous item purchased becomes the price for the first item to be sold. The cost of the last item you are buying should be the cost of the first item you sell. This culminates in the closure of inventory reported on the balance sheet as the cost of the earliest item that you purchased. Your ending inventory will be valued based on the previous costs. In an inflammatory environment, the LIFO method results in ending inventory that is less than the prevailing cost. Simply put, when prices are rising, the cost will be lower.
It is the easiest to calculate because it tells you the specific source of purchase inventory. It is used in high-priced inventory, like car sales. If a car dealership buys a vehicle at $20000 and sells it at $70000, they will want to show the exact cost of the sold car as opposed to another car. In other words, using unique identification helps you to match the inventory costs and the revenue generated.
With the advantages of Average Inventory costing aside, let’s look at a few drawbacks of the method.
Drawbacks of the Average Inventory costing method
It is only suited to identical items
You cannot use the Average Costing method in industries with items that are not similar. For instance, the electronics industry has a lot of devices with different parameters like model, size, color, and so on. Since these items are not identical, their prices will vary significantly.
It can affect reporting
A fluctuation in the cost of a stocked item can lead to errors in reported sales profit. As such, your pricing may never recover the cost of more expensive items, which means losses. You may even discontinue the thing and never recover your losses.
Product batches ought to match the amount
Should the number of your inventory items per batch be inconsistent, there will be a variation of costs assigned to each product. This leads to inaccurate cost values.
Confusion may arise if work-in-process inventory costs incurred by the manufactured items yet to be completed are processed together with the material costs. This is because the average cost method processes all costs on a single transaction before distributing them to all items.
Combining the cost and pricing strategy to determine the selling cost will not be a good idea. This is because each new purchase comes at a different rate than the previous one, changing the sales price. Such changes may not sit well with your customers, and it will also make it hard for you to create quotations for prospective clients.
It would be best if you had consistency when managing your inventory levels so that the process of filing taxes and comparing financial years becomes easier. Depending on what you are selling, the Average Cost Inventory method is the best option compared with the other methods. You can maintain your financial statements’ accuracy and track the value of inventory every year for proper accounting while you save time doing it.
Ensure that the method of inventory costing that you choose remains the same throughout. So, analyze the needs of your business carefully to help you choose the best method.