The benefits of using the average cost method
Of the three inventory valuation techniques, the average cost method is frequently the simplest to use and the least expensive to maintain. AVCO performs especially well in a few circumstances, such as when there are
What is the average cost method?
Instead of using the individual unit costs of a large number of similar units, the average cost method (AVCO) assigns a weighted-average cost to them. The cost of inventory items for an accounting period is determined using one of three inventory valuation methods, AVCO. First-in, first-out (FIFO) and last-in, first-out (LIFO) are the other two frequently used techniques. The cost of inventory at the end of the accounting period is easily calculated by giving the inventory items a weighted-average cost.
How to calculate the average cost method
You employ the AVCO formula to determine the weighted-average cost per inventory unit. The total cost of the inventory is divided by the total number of units in the inventory using this formula. The resulting quotient is the weighted-average cost per unit.
The average cost method formula is:
Weighted-average unit cost = total inventory cost / total inventory units.
Here are the steps for using the AVCO formula:
1. Determine the average cost of all purchased inventory
Find the total cost of each individual inventory item you bought first. Second, divide that sum by the number of items. The result is the average cost per item.
For instance, if a business spent $500, $300, $400, $700, and $600 on five inventory purchases in May, the sum of all five purchases equals $2,500. The business would then divide $2,500 by the total number of items it had purchased, or 575 items. The result would be a weighted average cost of $4. 35 per item ($2,500 / 575 = $4. 35).
2. Determine the average cost of all produced inventory
If a company produces its own inventory using raw materials, it would multiply the total cost of production by the total number of inventory items produced. The result is the average cost per item.
For instance, if a company produces its own T-shirts, it would add up the cost of all the raw materials used in the process, such as the fabric, thread, tags, dye, and any other purchases made. If the company spent $5,000 on all the raw materials and produced 800 T-shirts, the weighted-average cost would be $6 when $5,000 by 800 T-shirts is divided. 25 per T-shirt ($5,000 / 800 = $6. 25).
3. Calculate the total cost of sold inventory items
The T-shirt company, for instance, would multiply the 500 sold T-shirts by $6 if they sold 500 of the 800 T-shirts they produced in April. 25 weighted-average cost of each T-shirt. Inventory sold as a result would total $3,125 (500 x $6). 25 = $3,125).
4. Calculate the total cost of ending inventory
For instance, if the T-shirt manufacturer sold 500 of the 800 T-shirts they produced, 300 would still be in stock. They would multiply the 300 unsold T-shirts by the $6. 25 T-shirts with an average weighted cost of $6 each, total ending inventory of $1,875 (300 x $6). 25 = $1,875).
A periodic inventory system or a perpetual inventory system can both be subject to the AVCO formula. When using a periodic inventory system, the cost of goods sold and the value of ending inventory can be calculated by calculating the weighted average per unit, multiplying that figure by the quantity sold or the quantity in ending inventory, and then dividing the result by 100. Before each sales transaction, a perpetual inventory system allows you to determine the weighted average cost per unit.
Examples of the average cost method
You can learn how to use the AVCO formula to calculate the value of inventory on hand and the cost of goods sold during a specific month by using the periodic inventory and perpetual inventory examples that follow:
Average cost method
In June, a lighting company will decide what its AVCO for lamps will be:
When the total cost of all the items, $4,725, is divided by the total number of items, 300, the weighted-average cost per unit, which is determined, is found to be $15. 75 ($4,725 / 300 = $15. 75).
Periodic inventory
Using the lighting company as an example, 200 of the 300 units it had for sale during the month of June were sold.
It starts with the total number of items available for purchase (300), deducts the total number of items sold (200), and arrives at the number of items still in stock (300 – 200 = 100).
The cost of the items sold is then determined by multiplying the 200 sold items by the $15 weighted average cost. 75. This results in a $3,150 total average cost of goods sold (200 x $15). 75 = $3,150).
The cost for the items in ending inventory is then determined by multiplying the 100 items in ending inventory by the $15 weighted average cost. 75. This results in a total average cost of $1,575 for the last item in stock (100 x $15). 75 = $1,575).
Average Cost Inventory Method
FAQ
What is the average cost method formula?
Definition of the average cost method The average-cost method, also known as the weighted average cost method, is an accounting formula used to determine inventory value. The total cost of goods over a given accounting cycle is divided by the total number of goods to arrive at this number.
How do you use the average cost method in accounting?
Find the total cost of each individual inventory item you bought first. Second, divide that sum by the number of items. The result is the average cost per item.
What is the difference between FIFO method and average cost method?
When using this method to value inventory or determine delivery costs, even if accepting goods with varying unit costs, the average unit cost is determined by dividing the sum of all these unit costs by the number of receiving transactions.
