Key Takeaways
- Simplicity & Efficiency: The average cost method offers a straightforward, minimal-labor approach to inventory valuation.
- Consistency in Evaluation: Ensures compliance with generally accepted accounting principles (GAAP) by maintaining a consistent inventory valuation method.
- Balanced Financial View: Offers a balanced view of inventory costs, smoothing out price fluctuations over a period.
Image: Representation of the Average Cost Method
Understanding the Average Cost Method
Businesses engaged in selling products inevitably deal with inventory management, whether acquiring goods from manufacturers or producing them in-house. The average cost method simplifies the process by assigning a cost to inventory items based on the average cost of all goods available during an accounting period.
Inventory Valuation Techniques
To record the Cost of Goods Sold (COGS), companies generally choose from three primary inventory valuation methods:
- First-In, First-Out (FIFO)
- Last-In, First-Out (LIFO)
- Average Cost Method
The average cost method involves calculating a simple average of all inventory items, which helps in determining both COGS and the value of goods still available for sale at period-end.
Example of Average Cost Method
Take a look at this increased inventory detail for TechWave Electronics:
| Purchase Date | Number of Items | Cost per Unit | Total Cost |
|---|---|---|---|
| 1/1 | 25 | $980 | $24,500 |
| 1/10 | 30 | $1,050 | $31,500 |
| 2/05 | 35 | $1,120 | $39,200 |
| 2/20 | 20 | $1,210 | $24,200 |
| 3/01 | 40 | $1,300 | $52,000 |
| Total | 150 | $171,850 |
Assuming 90 units were sold in the first quarter, the total inventory cost would be $171,850, with an average cost of $1,145 per unit. The COGS would thus be 90 units × $1,145 = $103,050. The remaining inventory would be valued at 60 units × $1,145 = $68,700.
Benefits of Average Cost Method
- Ease of Application: Minimal labor is required to manage and calculate the average cost, making it an economical option.
- Stability & Consistency: Offers a balanced perspective by averaging out the cost per unit, providing a smoother valuation curve without abrupt changes.
- Simplified Tracking: Especially useful for businesses that sell indistinguishable and high-turnover inventory. Helps avoid the complexity of tracking individual item costs.
Special Considerations
Under GAAP, the consistency principle mandates that once an inventory valuation method is chosen, it should be maintained across periods. This helps in comparing financial statements year over year consistently.
For organizations that opt for the average cost method, consistency keeps financial reports reliable and aids in straightforward lateral comparisons.
Average Cost Method Formula
The average cost method is calculated using the formula:
Total Cost of Goods Purchased or Produced in Period ÷ Total Number of Items Purchased or Produced in Period = Average Cost for Period
This calculated average cost is then used to manage both COGS and the valuation of remaining inventory.
Why Choose Average Cost Method?
The average cost method simplifies inventory valuation, making it particularly suitable for businesses with high volumes of similar items. It facilitates easier and more accurate financial reporting by spreading costs uniformly over inventory items.
FAQs
Q: What are the major inventory cost methods accepted under GAAP?
A: GAAP permits multiple inventory valuation methods including FIFO, LIFO, and average cost method. However, IFRS does not allow LIFO, preferring valuation methods that reflect the actual flow of inventory.
Related Terms: FIFO, LIFO, COGS, GAAP, IFRS.
References
- BDO. “Accounting Changes and Error Corrections”.
- KPMG Advisory Services. “Inventory Accounting: IFRS® Standards vs. US GAAP”.
