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Home Valuation of Inventories Average Cost Method
 
 

Average Cost Method:

As the name implies, the average cost method prices items in the inventory on the basis of the average cost of all similar goods available during the period.

Example:

Assume that a company had the following transactions in the first month of operations.

Date Purchases Sold or Issued Balance
March 2 2,000 @ $4.00   2,000 units
March 15 6,000 @ $4.40   8,000 units
March 19   4,000 units 4,000 units
March 30 2,000 @ $4.75   6,000 units

Assume the company used the periodic inventory method, the ending inventory and cost of goods sold would be computed as follows using a weighted average method.

Date of Invoice No. of Units Unit Cost Total Cost
March 2 2,000 $4.00 $8,000
March 15 6,000 4.40 26,400
March 30 2,000 4.75 9,500
 
 
  10,000   $43,900
 
 
Weighted average cost per unit: $43,900/10,000 = $4.39
Inventory in units: 6,000 $4.39 = $26,340
  Cost of goods available for sale $43,900  
  Deduct: Ending inventory 26,340  
   
 
  Cost of goods sold $17,560  
   
 

If the company has a beginning inventory, it is included both in the total units available and in the total cost of goods available in computing the average cost per unit.

Another average cost method is moving average method, which is used with perpetual inventory records. The application of the average cost method for perpetual records is shown below:

Date Purchases Sold or Issued Balance
March 2 (2,000 @ $4.00)   $8,000   (2,000 @ $4.00)  $8,000
March 15 (6,000 @ $4.40)   $26,400   (8,000 @ $4.30)  34,400
March 19   (4,000 @ $4.30)  17,200 (4,000 @ $4.30)  17,200
March 30 2,000 @ $4.75   $9,500   (6,000 @ $4.45)  26,700

In this method a new average unit cost is computed each time a purchase is made. On 15 March, after 6,000 units are purchased for $26,400, 8,000 units costing $34,400 ($8,000 plus $26,400) are on hand. The average unit cost is $34,400 divided by 8,000, or $4.30. This unit cost is used in costing withdrawals until another purchase is made, at which time a new average unit cost is computed. Accordingly, the cost of the 4,000 units withdrawn on March 19 is shown at $4.30, a total cost of goods sold of $17,200. On March, following the purchase of 2,000 units for $9,500, a new unit cost of $4.45 is determined, resulting in an ending inventory of $26,700.

The use of average cost methods is usually justified on the basis of practical rather than conceptual reasons. These methods are simple to apply, objective and not as subject to income manipulation as some of the other inventory pricing methods. In addition, proponents of the average cost methods argue that it is often impossible to measure a specific physical flow of inventory, and therefore it is better to cost items on an average price basis. This argument is particularly persuasive when the inventory involved is relatively homogeneous in nature.

Relevant Articles:

Classification of Inventory

Difference between Perpetual and Periodic Inventory System
Basic Issues in Inventory Valuation
Average Cost Method
First In First Out (FIFO) Method
Last In First Out (LIFO) Method
LIFO Reserve
LIFO Liquidation
Basis for Selection of Inventory Method

 

 

A D V E R T I S E M E N T

 

Financial Accounting Topics


  Introduction to Accounting
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  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
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  Standard Costing and Variance Analysis
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 

 

 

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