Average cost method definition
/What is the Average Cost Method?
Average costing is the application of the average cost of a group of assets to each asset within that group. The concept is most commonly applied to inventory, but can also be used with fixed assets. For example, if there are three widgets having individual costs of $10, $12, and $14, average costing would dictate that the cost of all three widgets be treated as though they were $12 each, which is the average cost of the three items. This method can also be used to determine the average amount invested in each of a group of securities. Doing so avoids the larger amount of work required to track the cost of each individual security.
How to Calculate Average Cost
The average costing calculation for inventory is as follows:
Cost of goods available for sale ÷ Total units from beginning inventory and purchases = Average cost
The same approach to the calculation can be used for groups of fixed assets or securities.
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When to Use Average Costing
Average costing works well when it is difficult to track the cost associated with individual units. For example, it can be applied where individual units are indistinguishable from each other. The method can also be used when raw material costs move around an average cost point in an unpredictable manner, so that an average cost is useful for long-term planning purposes (such as in the development of a budget). Finally, average costing can be used when there are large volumes of similar items moving through inventory, which would otherwise require considerable staff time to track on an individual basis.
When Not to Use Average Costing
Average costing does not work well when the units in a batch are not identical, and therefore cannot be treated in an identical manner for costing purposes. It also does not work when inventory items are unique and/or expensive; in these situations, it is more accurate to track costs on a per-unit basis. Finally, average costing does not work when there is a clear upward or downward trend in product costs, average costing does not provide a clear indication of the most recent cost in the cost of goods sold. Instead, being an average, it presents a cost that may more closely relate to a period some time in the past.
Advantages of Average Costing
The average costing method requires little labor, and so is among the least expensive of the cost accounting methodologies to maintain (the other major cost accounting methods are the FIFO and LIFO methods). Also, unlike the FIFO and LIFO methods, the average costing method does not result in a number of cost layers, making the data easier to maintain. A further advantage is that it is relatively more difficult for someone to manipulate the reported level of profit or loss when this method is used. It is somewhat easier to engage in reporting fraud when the FIFO or LIFO methods are used.
Presentation of Average Costing
When average costing is applied to inventory, the nature of the method used is commonly included in the footnotes that accompany the financial statements. Investors may find this information useful. These footnotes are not released when financial statements are only being issued internally.
Terms Similar to Average Cost Method
The average cost method is also known as the weighted-average method.